Investing in real estate can provide significant profits, especially when you treat it as a long-term endeavor. The goal is to purchase a property, utilize your cash flow to pay off your mortgage, and sell the property while taking advantage of the appreciation it experiences in the meantime.
Real estate typically keeps up with inflation, making it a viable hedge and a stable investment. The catch is that you’ll be on the hook for maintenance, insurance, and taxes while you own the property, and in the case of rental properties, you’ll have to find tenants and collect rent.
You’ll also pay capital gains on the property’s appreciation. This guide explains how to avoid capital gains tax on real estate.
What Is Capital Gains Tax?
Capital gains tax applies to an investor’s profit when selling any investment. Real estate investors must pay this tax based on the appreciation the property experiences while they own it. A property you purchase for $200,000 and sell for $500,000 would provide you with $300,000 in profit, which is taxable income.
The good news is that long-term capital gains tax is typically lower than your income tax rate, although the exact percentage you’ll pay depends on your other income. Those with taxable income below $44,625 will pay 0% capital gains tax in 2023, those making between $44,626 and $492,300 will pay 15%, and people with an income of $492,301 or higher will owe 20%. (Note that these rates are for single filers.)
Variables Influencing Your Tax Liability
You should learn where the amount you owe in capital gains tax comes from before you begin looking for exemptions. The calculation is relatively simple, but some variables can affect your liabilities. This number is calculated using the following:
Your cost basis is simply the amount you originally paid for the property. This number is then compared to the amount you sell the home for to determine how much you owe in capital gains tax.
Adjusted Cost Basis
It’s possible to adjust your cost basis under some circumstances. You can add real estate agent commissions, legal fees, and closing costs to this number because they’re expenses you can’t avoid through the sale process. Adjusted cost basis can also apply to major renovations and additions partially responsible for the home’s current valuation.
The IRS allows you to depreciate the value of any rental property you own by 3.636% per year for 27.5 years to reduce your taxable income. Taking advantage of depreciation is helpful while you own the property, but depreciation recapture puts you on the hook for these deductions when you sell. Depreciation recapture is taxed as income, so you could end up owing considerably more than you thought.
Time Owning the Property
You’ll pay different tax amounts depending on how long you owned the property before selling. Long-term capital gains apply to any assets you’ve owned for more than one year and are taxed at a rate of 0%, 15%, or 20%, depending on your other taxable income. Short-term capital gains apply to assets held for less than a year and are taxed the same as income.
The final aspect that goes into determining your capital gains tax is the sale price. You’ll typically owe more in tax when the sale price is significantly higher than your cost basis. These numbers could influence your listing price because you want to ensure you get the most you can from the deal.
Figuring out how much you’ll owe in taxes is advisable before listing your property. You’ll want to do some basic calculations and begin uncovering ways to reduce your liabilities before you proceed.
Four Considerations for Reducing or Avoiding Capital Gains Tax
Your goal as a real estate investor is to maximize your profits as much as possible, and reducing the capital gains tax you owe is a step in that direction. You’ll have a few options for reducing your tax liabilities, depending on how committed you are to the cause. These considerations include the following:
1. Living There
Living in a home you own as your primary residence comes with some tax benefits. You can sell your primary home once every two years while receiving a capital gains exemption ($250,000 per person or $500,000 per couple). You’ll have to live in the house for at least two of the previous five years to receive this benefit, and you’ll still have to pay tax on appreciation beyond the $250,000 per person limit.
2. Seller Carryback
Many investors use their cash flow to pay down their mortgage as quickly as possible in hopes of owning the rental property outright before selling it. Owning the property outright allows you to offer a seller carryback, also known as seller financing, to potential buyers. The gist is that you’ll hold the mortgage for the buyer and will only owe capital gains tax on the monthly payments you receive from the purchaser.
3. Tax Harvesting
Some investments fail, but it’s possible to gain tax advantages from them if you sell at the right time. Those with depreciated stocks they’re holding onto in hopes of a rebound can sell them for a loss in the same year they sell a property, and the losses will offset some of your capital gains.
4. Section 1031 Exchange
Section 1031 of the Internal Revenue Code states that investors can sell an investment property and purchase a similar one while deferring capital gains until they sell the second property. This strategy works well if you’re looking to sell a property and reinvest the money into another one in a different part of the country or if you want to sell a single-family home and buy a multifamily one. The catch is that you can’t access any of the funds from the sale because they must go through a qualified intermediary.
Capital gains tax is part of life, but following these strategies can help minimize your burden. The result is more money in your bank account after completing your real estate sale.
Get the Advice You Need
Your real estate holdings should provide significant tax benefits. Speaking with a financial planning expert helps you determine the best way to reduce your capital gains tax exposure while making the most of this investment.
Bogart Wealth offers financial and investment management advice for our clients. We can provide insight into the best path to take with your real estate investments, helping you make the most of their benefits. Contact Bogart Wealth for more information on our investment services.