Selling a rental property isn’t as simple as taking the money and leaving. Depending on how much you earn and how long you’ve owned the property, you can incur significant capital gains tax (CGT) charges. That means you’re losing a revenue-generating asset and even paying a lot to get rid of it.
There are several ways to avoid capital gains tax when selling an investment property. These are all legal means to reduce the amount of tax you pay, so it’s within your rights to take advantage of them. Let’s look at three ways to lower your capital gains tax, plus some examples.
What is Capital Gain Tax?
A capital gains tax is a type of tax applied to the profits earned on the sale of an asset. Unlike taxes on ordinary income, which occur each year as new income is earned, capital gains taxes are only levied once the assets in question are actually sold. In other words, investors who have unrealized gains will not pay capital gains taxes on those investments until they actually sell those investments and realize their profits. The level of capital gains tax that an investor pays will depend on factors such as their income level, their marital status, the cost basis of their investments and the time they have held the asset.
Capital Gains Tax Rates
There are two kinds of capital gains taxes. Short-term capital gains occur when you held an asset for a year or less. These are taxed in the same way as ordinary income. If you own a property for a few months and sell it at a profit, it’s a short-term gain and is taxed at your marginal tax rate (tax bracket).
If you sell an asset you held for more than a year, any profit is considered a long-term capital gain. This is quite common in real estate. Long-term gains have their own tax brackets and are generally taxed at lower rates than ordinary income and short-term gains.
How to Reduce or Avoid Capital Gains Taxes
Capital gains taxes can take a significant bite out of your profits. But there are ways to reduce or even avoid these taxes on the proceeds from the sale. Here are three strategies.
- Turn Your Investment Property into Your Primary Residence
The easiest way to limit or avoid the capital gains tax is to convert your investment property to your primary residence. The reason? If you sell a primary residence, you don’t have to pay taxes on the entire gain. That’s because IRS Section 121 lets you exclude up to:
- $250,000 of capital gains on real estate if you’re a single filer.
- $500,000 of capital gains on real estate if you’re married and filing jointly.
To count as your primary residence, you must own and live in the house for at least two of the five years immediately preceding the sale. Say, for example, that you bought an investment property in 2010, and in 2015 you converted it to your primary residence. In other words, you moved in and called it home. In 2019, you can then sell the property as a primary residence because you lived in it (and owned it) for at least two out of the previous five years.
Of course, if the property you own is of significant value, the limit is $500,000 and not very useful.
- Use Capital losses to Offset capital gains
As anyone with much investment experience can tell you, things don’t always go up in value. They go down, too. If you sell something for less than its basis, you have a capital loss. Capital losses from investments—but not from the sale of personal property—can be used to offset capital gains.
If you have $50,000 in long-term gains from the sale of one stock, but $20,000 in long-term losses from the sale of another, then you may only be taxed on $30,000 worth of long-term capital gains.
$50,000 – $20,000 = $30,000 long-term capital gains
If capital losses exceed capital gains, you may be able to use the loss to offset up to $3,000 of other income. If you have more than $3,000 in excess capital losses, the amount over $3,000 can be carried forward to future years to offset capital gains or income in those years.
- Take Advantage of a Section 1031 Exchange
If you want to sell an investment property — but don’t need to cash out just yet, you can defer paying capital gains taxes by doing a like-kind exchange.
A 1031 exchange (or “like-kind exchange”) lets you defer taxes on the sale of an investment property by using the proceeds to buy another property. As long as you use the proceeds to re-invest, you can defer taxes on investment properties indefinitely.
You must buy the new property for at least as much as the other one sold for, or else you may have to pay capital gains tax on the difference. And you must carry as much or more financing as the original property. In other words, if you sell a property for $500,000 that had a $300,000 mortgage, your newly-acquired property must have an equal or greater purchase price and loan amount. Also, there’s a time limit because you need to identify potential replacement properties to buy within 45 days of the sale and close on the new property within 180 days.
- Take Advantage of a Qualified Opportunity Zone Fund or QOZ fund
A QOZ fund lets you keep all your cost basis in a property at time zero and invest the balance and then offers some very attractive tax incentives. For example, assume you sold a property for $1 million dollars that had no debt on it and your cost basis was $200,000. If you were to invest the $800,000 profit into a QOZ fund you would be able to pocket the $200,000 at time zero with no immediate tax consequences. You would defer the long term capital gains tax until April 15, 2027 and get earn a small tax reduction at that time and if you held the QIZ fund for at least 10 years you would be able to cash out of the fund 100% tax free.
In a nutshell, you defer taxes, then reduce then you eliminate them. These types of investments have grown in popularity since being made into law and most of the top institutional real estate sponsors and developers have designed products to meet consumer demand. Its worth exploring.
How Sera Capital Can Help with 1031 Exchanges and QOZ funds
First, we always recommend that any investor talk with a CPA or tax attorney who is knowledgeable about 1031 Exchanges and QOZ funds. Our experts can give you the most up-to-date details regarding each investment strategy and help you find the option that works best for you and your family. If you have questions on 1031 exchanges or QOZs contact us at Sera Capital for professional guidance.
If you want to see current DST offerings, DST properties or QOZs and you’re an accredited investor,