Key Takeaways
- Knowing how to avoid capital gains taxes can help homeowners keep a little more of the profits they earn when selling an appreciated asset.
- Avoiding capital gains tax on property that was recently sold is possible under the right circumstances.
- To avoid capital gains on home sales, there are three things that can help offset the resulting taxes.
Passive income investing has become synonymous with two very prominent benefits: cash flow and appreciation. The acquisition of a good rental property may reward investors with a proper wealth-building vehicle for years to come—if not a legacy that lasts decades or generations. Additionally, history has taught us that real estate tends to appreciate more often than not, allowing savvy investors to benefit from increased equity under the right circumstances. It is worth noting, however, that the latter isn’t without a significant caveat: capital gains.
While real estate appreciation is typically a positive, it can hurt an investor’s bottom line if they choose to sell the property in the future. That’s because the government requires homeowners to pay taxes on the capital gains they incur when the property is sold for more than it was originally purchased. Consequently, selling a home that has appreciated in value could result in a windfall of taxes.
While capital gains are a nuisance looming over many would-be sellers, there are some things homeowners can do to reduce their burden. For more information on how to ease the potential of capital gains on your own properties please reference the following.
How To Avoid Capital Gains Tax On Real Estate
In a market where appreciation has run rampant (not unlike today’s), capital gains may reach as high as hundreds of thousands of dollars—depending on the profits realized from a home sale. As a result, homeowners may have to pay upwards of 20% on their realized profits. Qualifying married couples filing jointly with a capital gain of $100,000, for example, could find themselves paying upwards $20,000 in taxes when they sell their home.
Fortunately, there are a few things homeowners and investors can do to offset their capital gains and perhaps even keep a little more of their profits from selling their properties.
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Offset Gains With Losses
One of the simplest ways to reduce your exposure to the capital gains tax is to offset the profits made from selling a home with losses that have been realized from another investment. While the Internal Revenue Service (IRS) does tax profits made from investments, they also allow investors to deduct losses from their taxable income. Otherwise known as tax-loss harvesting, this particular strategy reduces one’s exposure to the taxes levied on gains. By accounting for both gains and losses, investors can reduce the amount of capital gains they are taxed on.
Let’s assume, for example, you made $100,000 off the sale of your rental property, but proceeded to lose the same amount in the stock market. While the losses were unfortunate, they essentially offset all of the gains from selling the home. Subsequently, your net profits (when accounting for both investments) are essentially zero, which does nothing to increase your taxable income. Of course, you may only offset your gains with the amount of losses you claim (no more and no less). If you have no losses to claim, you may want to consider an alternative strategy to avoid capital gains taxes.
1031 Exchange
The 1031 Exchange, named after Section 1031 of the IRS tax code, allows investors to put off paying their capital gains taxes if they reinvest the proceeds made from selling a rental property into another investment. Of course, there are some things that must be taken into account before following through with a 1031 Exchange.
The subsequent property must be of a “like-kind,” meaning the property you buy after the sale of the original home needs to be the same “type.” That said, the IRS’s definition of “type” is relative. As a general rule of thumb, “like-kind” typically refers to properties that serve to generate income. It is entirely possible for an investor to sell a single-family rental and reinvest the profits into a multifamily property without triggering capital gains. To be absolutely certain the subsequent investment meets the “like-kind” criteria, however, be sure to consult a tax professional.
The timing in which a 1031 Exchange is carried out is just as important as the property types. In order for investors to avoid paying capital gains on their transaction, they must identify a potential replacement property within 45 days, and close on the new home within 180 days. Those who miss the deadline will be required to pay taxes on the sale of the original home.
The 1031 Exchange is a valuable tool for investors looking to shelter their profits from taxes, and it can be used as many times as necessary. However, taxes will be due the moment profits are actually realized. In other words, the 1031 exchange merely puts off paying capital gains taxes until sellers hold onto the proceeds from a home sale.
Convert Rental Property To Primary Residence
The IRS grants better tax benefits to those who sell a primary residence than investors who sell rental properties. More specifically, Section 121 of the IRS tax code “allows a taxpayer to exclude up to $250,000 ($500,000 for certain taxpayers who file a joint return) of the gain from the sale (or exchange) of property owned,” according to The Journal Of Accountancy. As a result, it’s becoming commonplace for rental property owners to convert their investments into primary residences before carrying out the sale of the subject property. That way, they’ll be able to offset some of the capital gains taxes levied in their direction.
In order to make the deduction, homeowners must meet certain criteria set forth by the IRS; namely, they must have owned the home for at least five years. Additionally, the homeowner must have lived in the subject property for two of the five years leading up to the sale. That’s an important distinction to make, as the amount of time the investor lives in the home (relative to the time it was placed in service) will help determine the amount that is allowed to be deducted.
Summary
The capital gains tax levied on homeowners at the time of a sale can significantly detract from any profits made on an investment, but fortunately, there ways to reduce exposure to such a burden. Tax-loss harvesting, 1031 Exchanges and converting rental properties into a primary residence can help investors defer or avoid paying some or all of their capital gains taxes. Consequently, learning how to avoid the capital gains taxes has more to do with offsetting or delaying the gains more than anything else.
Are you interested in reducing your exposure to the infamous capital gains tax? Let us know of any questions you may have in the comments below:
