Taxes on real estate profits can be deferred or even avoided if you prepare correctly ahead of a sale.
Here are the 8 most common strategies to defer capital gains tax that investors use each year.
What are Capital Gains?
Capital gains tax is a tax on the profit from selling a capital asset, such as a stock, bond, or real estate. Depending on the asset type and the time it has been held, the treatment of gains can vary.
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There are two main types of capital gains: short-term and long-term.
Short-Term Capital Gains
Short-term capital gains refer to profits on assets held for 1 year or less. These taxes will be the same rate as ordinary income which can be as high as 37%. So, if someone makes $35,000 per year and buys and sells a house as a flip and makes a $100,000 profit, that person would jump from the 12% tax bracket to the 24% tax bracket paying and would owe: $32,400 in taxes.
Long-Term Capital Gains
Long-term capital gains are gains on assets held for 366 days or more. The tax rate for long-term capital gains is typically lower than the rate for short-term gains. For individuals in the highest tax bracket, the current long-term capital gains tax rate is 20%. The tax for this scenario for the same income individual would be $24,200 which is almost $10,000 less.
1. Seller Finance
Seller financing in real estate refers to a situation where the seller of a property acts as the lender, providing all or a portion of the financing for the buyer to purchase the property. Along with the contract, the seller will create a promissory note, that outlines the terms of the loan, including the interest rate, monthly payments, and length of the loan.
Payments will be made directly to the seller or an escrow company as opposed to a bank. This is an attractive option for both parties if:
- The buyer does not qualify for traditional financing, or
- The seller wants to sell the property quickly and does not wish to wait to find a buyer with traditional financing.
- This also allows the seller to defer capital gains tax through installment sale payments.
When a property is sold, the seller is subject to capital gains taxes on the profit made from the sale. However, when the seller uses seller financing, these taxes are deferred by spreading the profit out over the life of the loan. This is done through a technique called a “installment sale”, which allows the seller to recognize the gain on the sale over the term of the loan, rather than all at once.
In an installment sale, the buyer makes payments to the seller, which include both interest and a portion of the principal. As these payments are made, the seller recognizes a portion of the gain on the sale and reports it as income on their taxes.
The benefit of this for the seller is that they can spread the tax liability over several years, rather than paying it all at once. This can reduce the overall tax burden and make it more manageable for the seller.
By donating a portion of the profits from the sale of real estate to a qualified charitable organization, sellers of real estate can use charitable donations to defer or avoid capital gains taxes on the profits from the sale of a property.
The IRS allows taxpayers to claim up to 30% of the seller’s adjusted gross income for a charitable contribution deduction for donations of appreciated property, such as real estate, as long as the donation is made to a qualified organization. The donation must be made in the same year as the sale of the property.
A creative method to defer capital gains taxes is by using a charitable remainder trust. To complete this, the seller donates the property to a charitable remainder trust, which sells the property. The proceeds are used to fund the trust. Once the trust is funded, the seller can receive income from it for a specified number of years or the remainder of their life.
Once the income interest ends, the remaining trust assets go to a charity of choice. The seller can claim a charitable contribution deduction for the present value of the remainder interest that will eventually go to charity, and the capital gains taxes are avoided altogether.
3. 1031 Exchange
A 1031 exchange, also known as a “like-kind exchange” or a “Starker exchange,” is a tax strategy that allows investors to defer paying capital gains taxes on the sale of an investment property by using the proceeds from the sale to purchase a similar property. The name “1031” comes from the section of the Internal Revenue Code that describes the rules for these types of exchanges.
To qualify for a 1031 exchange, the properties involved must be “like-kind.” This means that the properties must be used similarly. For example, an investor can exchange a rental property for another rental property or a piece of raw land for a developed piece of land. The properties are not required to be identical, but they must be exact in nature or character.
The process of a 1031 exchange typically involves three parties:
- The investor (seller),
- A qualified intermediary,
- The buyer.
The investor must sell the relinquished property and use the proceeds to purchase the replacement property within a specific time frame, usually 180 days. This limited time frame is often a challenge for some investors when considering the 1031 Exchange method.
The qualified intermediary holds the proceeds from the sale of the relinquished property until they are used to purchase the replacement property. This allows the investor to defer paying capital gains taxes on the sale of the relinquished property until the replacement property is sold.
When the replacement property is sold, capital gains taxes will need to be paid unless another 1031 Exchange is performed to continue the cycle.
4. Energy-Efficient Improvements
Energy efficient improvements are upgrades or modifications made to a property that help to reduce its energy consumption and costs. These improvements can be made to both residential and commercial properties and can include a variety of different measures such as:
- Insulation: Adding or upgrading insulation in the walls, attic, and floors can help to reduce heat loss in the winter and heat gain in the summer.
- HVAC systems: Replacing an old furnace or air conditioner with a newer, more efficient model.
- Windows and doors: Replacing old, drafty windows and doors with newer, more energy-efficient models.
- Lighting: Replacing old incandescent light bulbs with newer LED or CFL bulbs.
- Solar panels: Installing solar panels on the roof of a building can help to generate electricity, reducing the need to purchase power from the grid.
- Smart home systems: Installing smart home systems such as thermostats, lighting controls, and appliances.
Some government programs may offer tax credits or incentives for making these types of improvements.
Energy efficient improvements can help to defer capital gains tax in several ways:
- Cost segregation: By separating the cost of energy-efficient improvements from the cost of the property, an investor can depreciate the improvements over a shorter period of time, thus deferring capital gains taxes when investing in a new property.
- Tax credits: Some energy-efficient improvements qualify for federal or state tax credits, which can offset the cost of the improvements and reduce the overall tax liability.
- Conservation Easement: By donating a conservation easement on your property to a qualified organization, you can claim a charitable contribution deduction for the decrease in value of your property caused by the development restriction. This can help to reduce or avoid capital gains tax if the property was sold at a profit.
5. Bonus Depreciation
Bonus depreciation is a tax incentive that allows businesses to immediately write off a larger portion of the cost of certain property types, such as equipment and real estate improvements. This allows businesses to deduct a larger portion of the cost of the property in the year it was placed in service rather than depreciating it over several years.
The bonus depreciation percentage and the types of property that qualify for the incentive have changed over time. Since 2017, the bonus depreciation percentage has been set at 100%. This means businesses can immediately write off the entire cost of qualified property in the year it is in service rather than over several years.
This bonus depreciation applies to both new and used qualified property, including tangible personal property with a recovery period of 20 years or less, certain qualified film, television and live theatrical productions, and certain qualified improvement property.
It’s important to note that bonus depreciation is a temporary tax incentive and the percentage and types of property that qualify can change. Additionally, bonus depreciation can only be claimed by businesses and not by individual taxpayers, and the specific rules and regulations regarding bonus depreciation should be consulted with a tax professional.
6. Pre-Tax Retirement Account
A pre-tax retirement account is a type of investment account that allows an individual to make contributions to the account using money that has not yet been taxed. This means that the contributions are made with pre-tax dollars, and the money in the account grows tax-free until it is withdrawn in retirement.
The most common types of pre-tax retirement accounts are 401(k) plans and traditional Individual Retirement Accounts (IRAs). 401(k) plans are sponsored by employers, and employees can make contributions to the plan through payroll deductions. Traditional IRAs are individual accounts that can be opened and funded by anyone who meets the eligibility requirements.
Both 401(k)s and traditional IRAs have contribution limits, which change from year to year. These limits are set by the government and are in place to ensure that the accounts are used for long-term savings and not as a way to avoid taxes on short-term income.
When the money is withdrawn from a pre-tax retirement account in retirement, it is taxed as ordinary income. The advantage of a pre-tax retirement account is that it allows an individual to save for retirement and reduce their current tax bill, but the disadvantage is that the money will be taxed when it is withdrawn.
It’s important to note that there are also post-tax retirement accounts, such as Roth 401(k) and Roth IRA, in which the money contributed is taxed upfront but the withdrawals in retirement are tax-free.
7. Sell Property at Loss
It is not the most popular method, but investors can sell a property at a financial loss to reduce overall capital gains taxes. This is especially common when trading equities in the stock market and a particular stock trade has done exceedingly well, an investor may choose to balance the losses of another with the ability to avoid the total burden of capital gains taxes.
The same method can be had for a large real estate transaction in which an investor can use real estate to offset other gains in the portfolio and reduce capital gains.
The investor is possibly creating a ‘paper loss’ that does not accurately reflect the actual profitability of the transaction but simply needs a loss to offset capital gains. This is most often done using cost segregation studies and bonus depreciation.
8. Opportunity Zone Investment
Another tax loophole created by the Jobs act of 2017 is Opportunity Zone. This program provides tax incentives for investors to invest in low-income communities. It aims to stimulate economic development and job creation by providing tax benefits to investors who invest in these communities.
Designated by the governor of each state, Opportunity Zones are selected from a pool of low-income communities identified by the U.S. Census Bureau. These areas typically have high poverty rates, low median income, and a lack of investment.
Investors can invest in Opportunity Zones through Opportunity Funds, which are investment vehicles that pool capital from investors to invest in an eligible property located in Opportunity Zones. The primary tax benefit of investing in an Opportunity Zone is the ability to defer and potentially reduce capital gains taxes.
Proceeds from real estate that are invested into an Opportunity Fund within 180 days, can defer absorbing taxes on the capital gain until 2026. If the investment is held for at least five years, the investor can get a 10% reduction of the deferred gain, and if it’s held for at least 7 years, an additional 5% reduction. Additionally, if the investment is held for at least 10 years, the investor can permanently exclude the appreciation of the investment from capital gains taxes.
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As a top-performing sales professional in supply chain/logistics for almost 20 years, Jeff Davis has been putting his commissions to work for him in real estate since 2015 and is now partnered in almost 2000 units across 4 states in the US.