5 Ways To Defer Capital Gains Tax When Selling Real Estate

John Sculley once said, “Timing in life is everything.”

And when it comes to investing, developing the best timing to finalize tax planning can determine how effective they’ll be. 

I love passively investing in commercial real estate.

Especially real estate syndications

Depending on when a property is sold, it can generate huge profits along with large capital gains.

In this article, we’re going to highlight the top 5 tax deferral strategies you can use at year-end. But before we do, let’s first define what exactly capital gain taxes are.

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What is Capital Gain Tax?

A capital gain occurs when you sell an asset for more than you paid for it.

Here’s the formula: Capital Gain = Selling Price−Purchase Price

Not only does the government want a cut of your income, it also wants to tax you on the profits from your investments.

And that cut, my friend, is the capital gains tax.

According to IRS.gov, almost everything you own and use for personal or investment purposes are called capital assets.

Examples include:

  • your home
  • personal-use items like household furnishings
  • stocks or bonds held as investments

You have a capital gain if you sell the asset for more than your adjusted basis. You have capital losses if you sell the asset for less than your adjusted basis.

By the way, any losses from the sale of personal-use property, such as your home or car, aren’t tax deductible. So they take from you when you win and kick you when you lose. Good stuff, right?

The amount you’re taxed, if you have a capital gain, depends on how long you held the asset before selling.

What Is Short-Term Capital Gains Tax?

Any gains you make from selling assets you’ve held for a year or less are called short-term capital gains. Typically they’re taxed at the same rate as your ordinary income, anywhere from 10% to 37%.

What Is Long-Term Capital Gains Tax?

Long-term capital gains tax are based on profits received from the sale of an asset held for more than a year.

Depending on your taxable income and filing status, the long-term capital gains tax rate is 0%, 15% or 20%.

These rates are typically much lower than the ordinary income tax rates.

5 Ways To Defer Capital Gains Tax When Selling Real Estate

#1. Wait at least one year before selling your property

As we previously discussed, if you’re able to hold off at least one year before selling a property, it’s classified as a long-term capital gain.

Instead of it being considered a short-term capital gain (which can be taxed at a federal rate of up to 37%), instead it’ll be taxed at a much lower rate between 0% to 20%.

By using this strategy, you could reduce your federal capital gains tax burden dramatically.

#2. Utilize the primary residence exclusion

One of the questions people have involves paying taxes on the sale of their home. Typically selling a home doesn’t affect your taxes as even if there’s a profit, it can often be excluded.

This is something called “home sale exclusion”.

According to the IRS, if you have a capital gain from the sale of your main home, you may qualify to exclude up to $250,000 of that gain from your income, or up to $500,000 of that gain if you file a joint return with your spouse.

To qualify for this exclusion, you must meet both the:

  • ownership test
  • use test

You’re eligible for the exclusion if you have owned and used your home as your main home for a period aggregating at least two years out of the five years prior to its date of sale. You can meet the ownership and use tests during different 2-year periods.

However, you must meet both tests during the 5-year period ending on the date of the sale. Generally, you’re not eligible for the exclusion if you excluded the gain from the sale of another home during the two-year period prior to the sale of your home.

#3. Take advantage of a 1031 Exchange

The 1031 Exchange is defined under section 1031 of the IRS Code. This tax deduction strategy allows an investor to “defer” paying capital gains tax on an investment property when it’s sold.

The catch is that another “like-kind property” must be purchased with the profit gained by the sale of the first property following a strict timeline (see below).

Simply put, a 1031 exchange is a swap of one investment property for another that allows capital gains tax to be deferred.

In order to benefit from this rule, the IRS states that a specific timeline must be followed:

a) Exchange (sell) one investment property for another (like-kind). It must be real estate for real estate.

b) The property replacing the original property must be of equal or greater value.

c) Follow the rules of the 1031 exchange timeline.

  • Timeline #1 – You have 45 days after you sell your property to identify up to 3 new properties. This can be done in writing but you have to purchase one or more of them.
  • Timeline #2 – You have 180 days to close on one or more of the three properties that were identified.

d)  Must use an intermediary to help which means that all the funds need to go through a neutral party.

e) After agreeing on a sales price, the intermediary must wire the capital gains to the title holder/company.

f) Fill out the appropriate IRS form 8824.

#4. Utilize a deferred sales trust

A deferred sales trust is another method that can be used to defer capital gains tax.

For example, if you’re selling a property, typically you’d receive the sales proceeds at closing. By using a deferred sales trust, these proceeds are placed into this trust and only taxed as the funds from the sale are received.

This allows you to reinvest money from the sale into investment vehicles that aren’t allowed by other capital gains tax deferral strategies.

Internal Revenue Code 453 is a tax law that prevents a taxpayer from having to pay taxes on money they haven’t yet been received on an installment sale.

This is where the deferred sales trust comes in. The process works by selling the asset or property to the trust with an installment sale.

Next, the trust sells the asset to the buyer and the funds are placed in the trust without paying taxes on the capital gains. The trust doesn’t have any capital gains taxes because it sold the real estate asset for the same amount it paid for it with the installment sales contract.

If you’re the seller, because you haven’t physically received funds from the sale, you don’t pay any capital gains taxes yet.

With this set up, instead of the buyer paying you in one lump sum at the time of sale, the buyer agrees to pay you over multiple future installments which can start instantly or be deferred for several years. 

The third-party trustee can invest the funds however you like. You can earn interest income on the money from the sale while it sits in the trust and only begin paying capital gains taxes when you start receiving principal payments.

Here’s an image of the process courtesy of jrw.com:

#5. Opportunity zones

Another way to defer capital gain tax when selling real estate is by investing through a qualified opportunity zone (QOZ).

The Tax Cuts and Jobs Act passed by Congress in 2017 created this program which encourages real estate investors to put their money in low-income areas in the United States by offering significant tax benefits.

Capital gain tax on a property sale can be deferred by investing in a QOZ through qualified opportunity funds (QOF). The deferral is in effect until the investment is sold or exchanged or on Dec. 31, 2026, whichever comes first.

Similar to the 1031 exchange timeline, the QOZ investment program must also meet certain requirements.

Within 180 days of the sale of the property, the capital gains must be invested and needs to be exchanged for equity interest and not debt interest.

The time period in which the investment is held determines the amount of tax benefit received. 

For example, if the investment is held for at least:

  • 5 years – the basis of the investment increases by 10% of the deferred gain
  • 7 years – the basis of the investment increases by an additional 5% of the deferred gain
  • 10 years – the basis can be adjusted to its fair market value on the date it is sold or exchanged

Final Word

Too many people are focused on offense (making more money) when they should be focused more on defense (keeping the money they have).

Real estate investors can easily save thousands of dollars on capital gains taxes by using a few of the strategies mentioned in this article.

Make sure you speak with a qualified tax advisor to give you the best advice on which ones to choose.

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