Talk about the cost of capital gains taxes in real estate investing, and everyone has a story to tell. Every investor seems to think they are being taxed way too much on the profits from their real estate transactions – often without realizing that, in reality, they may not be paying as much tax as they think.
Why? Because many investors do not take capital gains taxes into account in calculating the return on investment for their real estate deals. It’s understandable. After all, what property investor sits down and calculates the amount of capital gains tax they paid on each deal to see if it aligns with their investment goals?
It would surprise you to find out how many investors do not even know that they can save money on capital gains taxes. They might realize greater returns if only they factored in the cost of capital gains tax when investing.
Many investors continue to make poor investments and live under financial stress because of their ignorance about the potential savings on their capital gains tax. For others, not taking taxes into account is simply based on sheer complacency – a lack of effort to do the computations and find out how much profit they are actually making.
In this article, we will look at ways where real estate investors can reduce their capital gains taxes on the sale of an investment property.
1. Deduct Expenses
When we sell a property, we call any profit or gain that we make from each sale as capital gain. The capital gains tax is the tax we have to pay for this profit. However, just because we have to pay tax does not mean we cannot reduce or even eliminate it.
So how do we reduce our capital gains taxes?
Any savvy business person would say we need to incorporate the cost of capital gains tax into our budget and make a financial plan for how to reduce it.
We can do this by deducting as much expense from the proceeds of sale as possible before we pay the tax. In reality, you can only deduct expenses that are directly related to your property – but this will still allow you to keep more of the profits for yourself.
Depreciation
Depreciation is an accounting method of allocating the cost of something over its useful life. We claim depreciation to show a smaller taxable profit.
For example, if you have $10,000 worth of renovation costs on your rental property and that item will last for another 20 years, you can claim depreciation over the next 20 years. This means you would only deduct $500 per year from your rental income in order to reduce your taxable income by that amount.
Depreciation will be much lower than the actual cost of a renovation because we spread it over its useful life. If you sell the property before the end of the useful life, you can deduct the balance of its value and reduce your capital gain.
But depreciation does not mean investors can claim anything and everything in their rental property. It must be an actual cost and directly related to the rental property.
Renovations And Improvements
Many improvements and renovations that add value to your property will reduce your capital gains taxes by increasing your basis. You calculate capital gains by subtracting your basis from the sale proceeds of the property.
Your basis starts at what you paid for the property when you purchased it. Any depreciation reduces this while improvements increase it. The higher the basis, the lower the capital gains taxes you will need to pay, so be sure to keep track of any improvements made to your properties.
Selling Costs
When you sell a property, there are certain costs that you should deduct from the proceeds of sale before you pay capital gains tax on the net gain. These selling costs include things such as legal and real estate agent fees which have to be paid, but you can reduce this by selling your property yourself.
There are also selling costs you must incur, such as the cost of advertising, replacing a lock box on your property, or any costs to prepare the property for sale. These are deductible as well because they have to be done in order for you to sell your real estate asset.
2. Buy Real Estate In An Opportunity Zone
Many investors may not even know about opportunity zones, but this tax break could help you keep more of your profit on a real estate investment. Opportunity Zones are specific geographic areas designated by the government with additional incentives for personal and business tax breaks – including capital gains taxes.
To take advantage of this tax break, an investor must invest in a business or real estate asset that falls within one of the approved opportunity zones. Capital gains tax on any profit from the sale of the liquidated asset within these zones can be deferred until 2026, as well as tax free capital gains on any asset located inside the opportunity zone. .
This is a brilliant strategy for investors who are looking to diversify their portfolios, defer capital gains tax on current assets, and enjoy tax free gains on future investments.
How To Identify Opportunity Zones
Opportunity zones are selected by local governments and approved by the federal government to attract money into specific areas. If your property is not inside an opportunity zone, this tax break does not apply. The best way to find out if a specific area is in an opportunity zone or not is by checking the government’s website.
Each opportunity zone was selected because there was a need and most likely experienced high levels of poverty. They also have other criteria such as areas in an empowerment zone or enterprise community, but you can check the government website for more information.
What is interesting about opportunity zones is that they can apply to any commercial investment, including real estate income properties. Opportunity zones are available in every state which makes it easier than ever to invest your money into an opportunity zone and get a tax break.
3. Use The 1031 Exchange
If you have made a significant investment into a real estate asset, then selling that property can give you a large capital gains tax which you must pay. However, there is a way to defer the payment of capital gains taxes by using the 1031 exchange strategy.
The 1031 exchange strategy is a method for deferring capital gains taxes on the sale of investment real estate. It allows you to reinvest that profit into another piece of investment real estate without having to pay any capital gains tax until you sell that asset, if ever.
Using this strategy, an investor can roll over their funds from the sale of their first investment property into a new building or real estate asset within 180 days.
How To Qualify For The 1031 Exchange
An investor can qualify for a 1031 exchange if he is buying an income-producing property or business that will increase his revenue. This means properties such as single family homes, multi-family buildings, retail space, office facilities, and industrial warehouses are eligible to use this tax strategy.
The purchase should also be from someone who is unrelated to the investor, and it must be a trade, not a sale without a replacement property being purchased.
4. Make The Investment Property Your Primary Home
To take advantage of tax-free capital gains when selling a property, the property must be regarded as your primary residence for two of the last five years. This means you cannot rent out the property during this time or you will lose all tax benefits associated with that sale.
However, if the investment property is an income-producing real estate asset, then this will not apply unless you move into it for at least two years.
So how much will you save in capital gains tax if you sell your primary residence after living in it for two years? The quick answer is that it will depend on the amount of the gain and your tax rate, but your exemption will be limited to $250,000, for a single person, and $500,000 for a married couple.
5. Avoid Selling Property Within A Year Of Buying It
Gains when selling a property within one year of purchasing it are known as short term capital gains and will require you to pay your ordinary income tax rate. Ordinary income is taxed much higher than capital gains so a strategy for real estate investors is to own a property for at least one year. After one year the taxes paid are capital gains with rates as low at 15%.
6. Leverage Tax Loss Harvesting
6. Leverage Tax Loss HarvestingAnother common strategy used to offset capital gains tax when selling a property is through tax loss harvesting. In simple terms, this IRS-approved practice allows investors to harvest any losses they have on an investment and apply them as deductions against their other income.
Since you will always have to pay capital gains tax when selling a property or it becomes subject to estate taxes, the loss harvesting strategy allows investors to take those losses and apply them against their other income.This could include losses from previous years which are referred to as carry forward losses.
If you have losses that you can use to offset gains, be careful to only use capital losses. You do not want to use losses that could offset ordinary income against capital gains as capital gains is a much lower tax rate. In those cases it might be smarter to hold those losses to offset earnings taxed at a higher rate.
7. Time Your Sale When Income Is At Its Lowest
Capital gains are typically taxed at favorable rates. This is true if you have owned the asset for at least one year. The long term capital gains rate is only 15% for income levels of $40,401 to $441,850 which most people will fall into.
If you have large gains or high ordinary income, you could see your capital gain rate jump 25% to a whopping 20% capital gain tax rate, so plan ahead. If you have income over $441,850 at any given year, you might want to delay the sale of an asset until your income drops below that amount.
Further, if you plan to have an income year less than $40,400, which will include the gain, you will pay no capital gains at all. Consider assets you will take losses on and try to time paying gains on good assets with the deduction of the loss on bad assets and just maybe you can avoid paying any gains at all.
8. Implement An Installment Sale Strategy
Another way property investors can reduce capital gains tax is by selling their assets with an installment sale strategy. This means the seller will only capture a portion of the profit because the buyer will be paying for the property over time by paying interest and principal payments on a loan.
If timed correctly, you can pay the least in capital gains taxes by keeping your income in any given year at the lowest possible level. Although you will still have the same gain over time, an installment sale spreads that gain out and gives you more control on when you will need to pay taxes on those gains.
9. Invest In Real Estate Through Your Retirement Account
Did you know you can buy property with your IRA? The great thing about an IRA is it gives you tremendous tax advantages. For a traditional IRA, you will not pay any taxes on any income or capital gains until you start to withdraw the money.
That means you can defer taxes until you are ready to use the money. Keeping more money in the account instead of paying taxes as you accelerate the growth in your retirement accounts.
Roth IRAs are post tax investments, which means you paid the tax on the money before you put it into the account. In these accounts, you will never pay tax again so any gains you make inside your Roth IRA are 100% tax free!
You Can Save More Money When Selling Your Property
As you can see, there are several ways to lower your capital gains tax liability when you sell your property. Some strategies like IRAs and primary homes can completely eliminate the need to pay any taxes on gains at all. Keep these strategies in mind and plan ahead before you sell a real estate asset that will produce a gain.