How To Avoid Capital Gains Taxes
As you work to learn the ins and outs of the real estate trade, one crucial skill you’ll need to learn is how to adjust your strategy based on market changes. That way, you can sell when you’ll have the greatest chance of a high return.
One aspect of the market that sometimes seems counterintuitive is the rise in prices. As costs go up, so does the cost of living—including home prices. In fact, over the course of the last recession, median home prices have increased over 150% nationwide—with some market increases recorded at a whopping 300%.
If you’re smart (and, if you’re reading this, I’m sure you are), you’ll want to maximize your earning potential on this equity. One of the ways to do this is to avoid capital gains taxes—the share of your revenue that the IRS demands.
Anyone who has dealt with capital gains taxes knows they can be pretty high: 15% for single filers with taxable income up to $418,400 ($470,700 for married filing jointly), and 20% for higher annual income bracks. These taxes get bundled in with a 3.8% net investment income tax (which is embedded in the Affordable Care Act), and a 10% (or so) state tax. A depreciation recapture tax adds another 25%. That means that, depending on your state of residence, you could easily pay 30% to 40% in taxes when you sell your next asset. Ouch.
Upon selling equity, real estate novices typically just pay their capital gains taxes and move on with their lives. There’s nothing wrong with this approach, per se, but if you’re really looking to maximize your profits, there’s a smarter way to go about it—and it doesn’t require breaking a single law.
In this article, we’re going to explore two of the most powerful ways to reduce or avoid capital gains taxes on your equity proceeds. Learn them well; they could save you thousands of dollars on your next deal.
Option 1: The 1031 Exchange
When people ask, “How do I avoid taxes on my capital gains?”, “Do a 1031 exchange.” is often the first answer they hear. With this method, you can reduce capital gains taxes long term and pay what remains at a later time.
Basically, you take your total proceeds from the sale of your investment property and purchase a property of lesser or equal value (aka. a “like-kind” asset). By doing this, you move your gains to the new property and avoid paying gains taxes—at least for now. The taxes you would have owed are deferred to that new asset. With this method, you can also “reset” your depreciation, which has its own advantages when it comes to tax breaks.
Of course, every good idea has its drawbacks. For the 1031 exchange, you’ll only have 45 days to choose your “like-kind” asset. Other deadlines will apply to the closing as well, based on the details of the sale.
Also, keep in mind that a 1031 exchange does not eliminate your tax obligation. Once you decide to sell your new asset, you’ll need to pay those capital gains taxes.
Until you sell your new like-kind asset, you cannot access any of that equity, so your pay day will have to wait. You’ll also be exposing your new investment to the usual ups and downs of the real estate market. Any decrease in value means you’ll incur that loss directly.
Finally, you’ll also be responsible for managing and maintaining your new property. If you’re an investor that’s looking to liquidate your portfolio and stop being a landlord, this is not the tax option for you.
So, here’s the 1031 exchange in short:
- Defer Capital Gains Taxes To A New Property
- Allows You To Enter New Markets
- Resets Your Depreciation Timeline
- You Must Complete The Process On Strict Timelines
- You Cannot Access Your Equity. Any Uninvested Dollars Will Be Taxed
- You Must Pay Capital Gains Taxes Eventually. They Don’t Go Away, They Are Simply Deferred
- You Are Still A Landlord
- You Are Exposed To Ebbs And Flows In The Market
Option 2: The Installment Sale
Seasoned investors often recommend an installment sale as a less common, but still viable, option for avoiding capital gains taxes. This lesser-known strategy is growing in popularity because it offers many advantages that a 1031 exchange does not. According to Section 453 of the US Tax Code, which pertains to installment sales and related tax provisions, an installment sale allows investors to sell their property, defer capital gains tax, and roll the money into non-real-estate investments.
With this method, you will only be required to pay capital gains taxes on money that you have received. This is a big deal because, as you may have guessed, an installment sale involves structuring an installment contract for your deal that spans over multiple years. That means you will only be held responsible for the principal portion of funds received each year. So, instead of paying all your gains taxes in one lump sum, you can pay it in more affordable (and less impactful) installments.
Plus, the money you earn from the sale will not be tied to any assets or restrictions. So, you can feel free to use or invest it as you see fit.
Sounds too good to be true, doesn’t it? It gets better.
You know that multi-year contract you started to sell your investment? You earn monthly interest on that—on top of the principal payments. That means you can pay off your capital gains taxes each year with the interest you earn from carrying the installment contract, then pocket the rest as income.
Here’s an example: Let’s say you’re selling a long-standing investment for $1,000,000—with a capital gain of $500,000. Normally, you would pay the capital gains taxes on that $500,000 at closing, which can add up to over $100,000, depending on your tax bracket and state.
Alternatively, drawing up an installment contract would require the buyer to pay you over a predetermined period. This can potentially save you money on taxes over time, especially since you’ll be earning more via interest. Plus, if you defer your principal payments and only receive interest each month, you’ll technically incur zero capital gains. No additional gains. No additional capital gains taxes. Depending on how long you hold the installment, you could make enough interest to pay off your capital gains taxes and pocket hundreds of thousands of dollars in income.
Another major benefit of the installment sale is related to lifestyle. In this way, you can keep that cash flow you gain from your real estate assets, while simultaneously eliminating any responsibility you once had to the property or tenants. Your new role is basically like that of a bank. You just sit back and collect on your investment.
So, here’s the installment sale in short:
- Someone Else Pays Your Capital Gains Taxes For You
- You Aren’t Deferring Taxes Like A 1031 Exchange, You Are Eliminating Them
- No More Being A Landlord Or Responsible Party To A Piece Of Real Estate
- You Have Access To Your Equity To Live Off Or Invest Elsewhere
- Earn Considerably More Than The Sale Price On Your Real Estate
- Enjoy Monthly Passive Income
- Typically Takes A Few Years To Fully Pay Off Your Capital Gains With The Interest You Earn
- You Must Find A Buyer Willing To Work On These Terms With You
- Interest Is Taxed As Regular Income
In conclusion, both the 1031 Exchange and the Installment Sale methods are effective, but may not be suitable for everyone. It really depends on what you want to do with your future investments. If you want to stay in real estate, don’t mind being a landlord, and are okay with an exposure to market changes, a 1031 exchange could be a good option for you. If you are looking to get rid of your capital gains taxes all-together, are tired of being a landlord, and are looking to enjoy some passive income, an installment sale could be the right fit. Either way, Central Coast Home Buyers is here to help you through the process. We have done hundreds of these transactions. We may even buy your house from you directly if it meets our criteria. Call us at (805)505-7373 today or fill out this short form below: