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When selling an investment property, you may worry about giving up some of the gains you’ve realized from your investment to capital gains taxes. Property owners have various legal strategies that may allow them to mitigate or manage their capital gains tax liabilities from selling their properties.
Contact 453 Deferred Sales Trust Powered by Pennington Law for advice and support in building a strategy designed to help you keep more of your wealth when selling an investment property. We are recognized as the Best Deferred Sales Trust Law Firm in the U.S. for 2024, and we’re here to help you keep more of the wealth you’ve worked hard to earn.
What Goes Into Capital Gains Tax on Investment Property?
When you own a piece of real estate as an investment, you must pay capital gains tax on the increase in value of the property during your ownership when you sell the real estate. Taxing authorities determine capital gain (or loss) by subtracting the dollar amount an owner sells their property for from the price the owner paid to purchase the property.
For example, suppose you purchased a property for $500,000 and eventually sold it for $700,000. In that case, you will owe capital gains tax on the $200,000 in gains you realized from the sale. However, various tax rules may allow property owners to take some deductions from their capital gains. The federal government taxes capital gains differently depending on whether a party realizes a short-term or long-term gain from the property sale.
What Are the Best Ways to Avoid Investment Property Capital Gains Tax?
Some of the most common strategies for managing or mitigating capital gains taxes from selling investment properties include the following:
Live at the Property
Federal tax laws allow property owners to take a capital gains tax exemption of $250,000 (or $500,000 when filing jointly with a spouse) when selling a primary residence. To qualify for the exemption, a property owner must meet the ownership and use tests under IRS rules. Under the ownership test, an owner must have owned their property for at least two of the five years prior to the property’s sale. Under the use test, the owner must have used the property as their main home for at least two of the five years prior to the property’s sale.
An owner can meet the ownership and use tests in two different two-year periods in the five-year lookback period. However, a person may not use the exemption if they took an exemption on the sale of another home within the past two years.
Offer Seller Financing to Potential Buyers
A property owner who owns the property outright (e.g., does not have an outstanding mortgage) may choose to offer seller financing to a prospective buyer, in which the buyer makes monthly payments to the seller rather than to a mortgage company.
Like a bank, the seller can finance the purchase price over a term of years at an agreed-upon interest rate. When structured correctly, a seller-financed sale of real estate may entitle the seller to spread out capital gains tax payments over the financing term, as applicable tax laws may require the seller to pay capital gains tax only on the payments they receive from the buyer in a tax year.
Take Qualifying Deductions
Property owners may reduce their capital gains on a sale and thereby the taxes on the sale by taking qualifying deductions related to the property, such as qualifying expenses for major home improvements or qualifying costs incurred to sell the home.
For example, suppose a homeowner realizes a $200,000 gain on the sale of their property; however, just prior to selling the property, the owner put solar panels on the property for $35,000. In that case, the homeowner may qualify to reduce their gain on the sale to $165,000.
Utilize Tax-Loss Harvesting
The tax-loss harvesting strategy involves selling assets that have depreciated since purchase to offset gains from selling other assets that have appreciated. However, tax-loss harvesting has several considerations and limitations.
For example, a party may not sell investments held for a year or less and use the losses from that sale to offset capital gains tax on the sale of a property owned longer than a year. This is because federal tax law taxes long-term capital gains (gains from an asset held for longer than a year) at different tax rates than short-term capital gains/losses, which federal law taxes at the ordinary income tax rate. Furthermore, taxpayers cannot claim an investment as a loss if they repurchase it within 30 days. However, when a taxpayer’s capital losses exceed their gains for the year, they may use some of that loss to deduct their ordinary income (up to a limit) and can carry over unused losses to future years.
Make Charitable Donations
Charitable donations give property owners access to tax benefits they may use to offset capital gains taxes from a property sale. Qualifying donations may allow taxpayers to take corresponding deductions on their taxes.
Reinvest in New Property with a 1031 Exchange
1031 exchanges allow property owners to reinvest the proceeds from the sale of a parcel of real estate into a new parcel, subject to various requirements and restrictions, while deferring capital gains taxes from the sale.
First, the sale of the old property and purchase of the new property must occur in an integrated transaction, usually conducted through an exchange facilitator, under an agreement that complies with federal tax regulations. Furthermore, a person may only use a 1031 exchange to defer capital gains taxes on real estate sales.
1031 exchanges also have a “like-kind” requirement, interpreted to mean that a property owner must reinvest the sale proceeds into another parcel of real estate of equal or greater value than the sold property; the owner must use both the old and new properties for a trade or business or as an investment.
Finally, the 1031 exchange rules impose several time limits on reinvesting the sale proceeds for a property owner to defer capital gains taxes on the sale. Failing to meet the time requirements will cause the exchange to fail, meaning the property owner will lose the benefit of deferring capital gains taxes.
Work with a Lawyer Who Practices IRC 453-Specific Matters
An attorney with extensive experience developing legal and financial strategies that leverage the taxation rules under IRC 453 can help you identify options that may help you manage or mitigate capital gains taxes from a property sale.
For example, a lawyer can help you evaluate the suitability of strategies such as seller financing or deferred sales trusts, which we call “The Tax Tool You Didn’t Know You Had.” Working with an attorney knowledgeable in IRC 453 strategies can help you set up your sale correctly to comply with IRS rules and avoid potentially losing critical tax benefits that allow you to defer capital gains taxes from property sales.
How Much Capital Gain Can I Exclude?
The amount of capital gain you might exclude when selling real estate may depend on the tax rules or legal strategies you use. For example, when selling your primary residence, you can exclude $250,000 of capital gain ($500,000 when you file jointly with your spouse). When you make improvements to your property before selling it, the expenses you can deduct from the capital gain depend on the type of improvement.
Other legal options allow you to exclude capital gains tax for an extended period or indefinitely. For example, seller financing of a sale spreads capital gains taxes on the sale, as you only pay tax on the buyer’s payments during the tax year.
Furthermore, a Section 1031 exchange or deferred sales trust can defer capital gains tax indefinitely. In a 1031 exchange, a property owner pays no capital gains tax if they conduct a real estate sale and use the proceeds to purchase new real estate in an integrated transaction that meets the requirements for 1031 exchanges. Deferred sales trusts may allow property owners to defer capital gains tax as long as the trust does not pay any of the principal from the property sale proceeds.
What Is the Difference Between Short-Term and Long-Term Capital Gains?
Federal tax law imposes different tax rates on short-term and long-term capital gains. Gains from a property sale qualify as short-term gains when an owner has held the property for a year or less. Gains become long-term gains when an owner holds their property for more than a year. The Internal Revenue Code taxes short-term capital gains at the ordinary income tax rate that a taxpayer pays in the tax year. However, the federal government has a different capital gains tax structure for long-term gains.
Most taxpayers pay a 15 percent capital gains tax on long-term capital gains. However, high-income taxpayers will pay a 20 percent tax rate on long-term capital gains; the income thresholds to trigger 20 percent taxation will depend on a taxpayer’s filing status (i.e., single, married filing jointly, married filing separately, head of household). In addition, low-income taxpayers may pay no capital gains tax on long-term capital gains.
Contact Our 453 Deferred Sales Trust Lawyers Today
Contact 453 Deferred Sales Trust Powered by Pennington Law today for a free, no-obligation consultation. Our legal team is here to discuss strategies for minimizing capital gains tax, allowing you to preserve more of the wealth you’ve built in your investment property.
