How To Avoid Capital Gains Taxes
As experienced real estate professionals, we’re always on the lookout for new ways to adjust our strategy based on changes in the markets. This helps us to take advantage of the best opportunities and increase our chances of higher returns on new deals.
Since the last recession, median home prices have increased over 150% nationwide—as high as 300% in some places. While this can be beneficial for us overall, as we earn more from each sale, we also end up owing more in capital gains taxes.
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.
As smart investors, we want to avoid capital gains taxes as much as possible—and maximize the earning potential on our equity. Now, we’re going to teach you how to do that too. Sure, you could just pay your capital gains taxes and move on with your life. However, if you’re really looking to boost your profits, there’s a smarter way to handle taxes—two ways, actually—and they’re both completely legal.
So, brace yourself for some expert advice and save thousands of dollars on your next big deal. You’re welcome.
Option 1: The 1031 Exchange
This is the most common method to avoid or reduce capital gains taxes. With this method, you can defer your tax obligations for a later time, giving you more opportunities to maximize what you earned on your latest sale. After selling an asset, immediately reinvest your total proceeds in a new, “like-kind” asset.
There are several benefits to this method:
- Taxes are temporarily deferred.
You’ll move your gains to the new property and avoid paying gains taxes. This is because the taxes you would have owed on your sale are deferred to that new asset.
- Depreciation gets reset.
This method also allows you to reset your depreciation timeline, which offers you additional tax benefits in the future.
- You can enter new markets.
Reinvesting in a new asset gives you an opportunity to explore new markets and further diversify your portfolio.
Before you run out and set this deal up for yourself, keep these drawbacks in mind:
- There are some restrictive deadlines.
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.
- You still have capital gains tax obligations.
A 1031 exchange does not eliminate your owed taxes; it merely delays them. Once you decide to sell your new asset, you’ll need to pay taxes on any capital gains.
- You’ll be responsible for managing your property.
If you’re an investor that’s looking to liquidate and stop being a landlord, this is not the tax-saving option for you. You’ll need to manage your new property, just as you did before.
- Continued exposure to market changes
Until you sell your new like-kind asset, it will continue to be exposed to the usual ups and downs of the real estate market. Any decrease in value means you’ll incur that loss directly.
- No access to earned equity.
Because you need to immediately reinvest the equity from your recent sale, you won’t have access to that revenue—not until you sell your new asset and pay your taxes.
Pros
- Defer Capital Gains Taxes To A New Property
- Allows You To Enter New Markets
- Resets Your Depreciation Timeline
Cons
- 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
This is a less common, but still viable, option for avoiding capital gains taxes. It also offers many advantages that a 1031 exchange does not.
According to Section 453 of the US Tax Code, an installment sale allows investors to sell their property, defer capital gains tax, and roll the profits forward as they see fit. It involves the creation of a multi-year installment contract, allowing you to pay your capital gains taxes in more affordable (and less impactful) installments instead of one lump sum.
There are several benefits to this approach:
- Reduced capital gains taxes.
With this method, you will only be required to pay capital gains taxes on money that you have received. This means that you can pay on your profits as you earn them, making the installments much more affordable. Plus, since you’re earning monthly interest (see below), you can potentially use that to help you pay your taxes, avoiding the need to include payments in your budget.
- Less responsibility.
Your new role is basically like that of a bank. You just sit back and collect on your investment. Keep the cash flow you gain from your real estate assets, while simultaneously eliminating any responsibility you once had to the property or tenants.
- Monthly passive income.
Drawing up an installment contract would require the buyer to pay you over a predetermined period. You earn monthly interest on the installments paid to you by the buyer in addition to principal payments. Plus, if you defer your principal payments and only receive interest each month, you’ll technically incur zero capital gains. With all this in mind, you can pay off your capital gains taxes each year with the interest you earn from carrying the installment contract, then potentially pocket hundreds of thousands of dollars in income.
- Access to your equity
The money you earn from the sale will not be tied to any assets or restrictions, so you can feel free to invest it as you please.
Of course, there are some drawbacks to this method as well:
- Takes time to pay capital gains with earned interest
If you decide to try paying on your capital gains using only the money you’re earning as interest, resolving your capital gains debt can take some time. If you’d rather not have that responsibility hanging over your head, this approach may not be the right one for you.
- Must find a buyer
Not everyone wants to be stuck with a long-term payment agreement. The key here is to find a buyer that stands to gain just as much (if not more) than you. You’ll both benefit in the long run.
- Interest is taxed as income
Despite the increased earning potential, you’ll have to keep in mind that that’s just what the IRS thinks too. They’re going to want to see their cut of your earned interest. Keep that in mind when you’re calculating your potential tax payments.
Pros
- 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
Cons
- 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
Both of these 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 altogether, are tired of being a landlord, and are seeking passive income, an installment sale could be the right fit. Either way, PDX Home Buyers is here to help you through the process. Call us at (503) 893-9107 today or fill out this short form below:
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