Capital gains taxes can significantly reduce the net proceeds from the sale of investment property. These gains are generally taxable at the federal level when an asset is sold for more than its adjusted basis. Eliminating capital gains is not possible in most cases, investors may consider using approved strategies to defer the tax liability and improve after-tax outcomes.
Investors have several options to delay tax payments for capital gains. From leveraging 1031 exchanges to establishing charitable remainder trusts, each with distinct requirements and planning implications. Below, Realized 1031 has shared a guide outlining these options to help investors explore tax deferral for rental property, commercial buildings, and other qualifying assets.
Capital gains taxes are the taxes imposed on gains realized during the sale of an asset. Let’s say that you bought an apartment complex a few years ago for $2,000,000. Today, you sold it for $2,700,000 thanks to favorable market conditions. The gross capital gain is $700,000. However, the taxable gain may be reduced by transaction costs and increased due to depreciation recapture, depending on how the asset was used and reported.
The rates depend on how long you held the property. Short-term capital gain tax rates are for those you held for less than a year and are taxed at ordinary income tax rates. Meanwhile, profit from assets held for longer than a year will be taxed at long-term capital gains tax rates. Those in the highest tax bracket will have 20% as the maximum rate (plus a possible 3.8% Net Investment Income Tax).
Based on our example above, you may need to pay up to $140,000 to the IRS and we haven’t included potential capital gains taxes at the state level and depreciation recapture obligations. It comes as no surprise that many investors consider strategies to defer capital gains on investment property. How do you defer capital gains tax on investment property? Here are some of the strategies you can leverage.
One of the more widely used options today is the 1031 exchange. This transaction is also called the like-kind exchange, and it involves “swapping” two qualified real properties held for investment or business use, enabling the deferral of capital gains tax by avoiding a taxable sale event. Done correctly, you can defer all your capital gains from the relinquished property, paying it only when a taxable event occurs.
Due to the significant deferral benefit, the IRS has set strict rules surrounding the 1031 exchange to avoid abuse. Here are some of the core requirements.
Despite these requirements, 1031 exchanges remain a commonly implemented strategy due to benefits such as tax deferral, portfolio consolidation or diversification, and the ability to exchange repeatedly over a lifetime, potentially passing assets to heirs with a stepped-up basis.
For those who own rental property, like multi-family homes, converting this asset to a primary residence may enable the use of the capital gains exclusion. Under IRS rules, if you live in the property as your primary residence for at least two out of the five years before the sale, you may qualify for the Section 121 exclusion. This allows individuals to exclude up to $250,000 (or $500,000 for married couples filing jointly) of capital gains from taxation.
What if the property was acquired through a 1031 exchange? The Section 121 exclusion can still apply, but there’s one more consideration to keep in mind: the holding period for the 1031 exchange property. The IRS will require you to hold the real estate asset for business or investment use. Immediately converting it to a primary residence may lead to IRS scrutiny and, in the worst-case scenario, the loss of your tax-deferred status. As such, you must own the property for at least five years and use it for income-generating activities for at least two years before you can sell it and leverage the tax exclusion.
This strategy won’t reduce your capital tax gains directly, but may help reduce your overall tax liability within the year. Scheduling the sale of your property during a time when you sold other assets at a loss allows you to take advantage of tax loss harvesting. This is the practice of offsetting capital gains with capital losses to reduce your taxable income.
Under IRS rules, capital losses are first applied against gains of the same type (short- or long-term), and any excess loss may offset other gains. If net capital losses remain after offsetting gains, up to $3,000 ($1,500 if married filing separately) can be deducted against ordinary income annually, with additional losses carried forward to future years. Given the complexity of this strategy, make sure to consult with tax professionals before trying it.
A Delaware Statutory Trust is an investment vehicle that allows you to own fractional interests in real estate through a trust. In turn, this trust owns a potentially income-generating property. You may receive periodic distributions based on the trust’s performance through rental payments, appreciation, and other strategies employed by the sponsor.
DSTs are commonly used to complete 1031 exchanges, as fractional interests in DSTs have been recognized as qualifying like-kind property under Revenue Ruling 2004-86. This enables investors to defer capital gains tax when exchanging into a DST structure, provided all IRS requirements are met. Other potential benefits include:
DSTs also involve risks. Investors have no control over property management or disposition, and illiquidity is a significant concern—interests in DSTs cannot easily be sold or exchanged. Distributions are not guaranteed and depend on property performance, market conditions, and sponsor effectiveness. Additionally, if IRS rules under Revenue Ruling 2004-86 are not strictly followed, 1031 exchange eligibility may be jeopardized. Investors should carefully review the private placement memorandum (PPM) and consult legal and tax advisors before investing.
A deferred sales trust is a type of installment sale. In this case, you transfer the property to the trust, and the trust sells the property on your behalf. The trust holds the sale proceeds and pays you in scheduled installments over time. This deferral strategy allows you to pay small amounts of capital gains taxes over time instead of a one-time payment.
Unlike a 1031 exchange or a Delaware Statutory Trust, there is no strict requirement for like-kind replacement property. A couple of things to be aware of are that you won’t receive the full proceeds upfront and you remain subject to income tax rates on each installment payment, which may be higher than long-term capital gains rates. As such, deferred sales trusts offer flexible, customized tax deferral, but are most suitable for investors willing to surrender immediate access to proceeds and who are comfortable with trust administration.
Investing through retirement accounts like IRAs or 401(k)s allows for tax-free growth of your investments. When you buy and sell assets within these accounts, you don’t pay taxes at the time of each transaction. Instead, taxes are deferred until you withdraw funds and withdrawals are taxed as ordinary income. This happens typically during retirement, and by this time, your income and tax bracket may be lower. In a Roth IRA, qualified withdrawals are even tax-free, including gains if certain holding and age requirements are met.
This tax treatment may enhance the compounding potential of investments over time. However, early withdrawals may be subject to income tax and a 10% penalty, unless an exception applies. As such, retirement accounts can be powerful tools for long-term tax management and wealth planning when used appropriately.
A charitable remainder trust (CRT) is another tax-advantaged estate and philanthropic planning tool that allows donors to convert appreciated assets into a stream of income while ultimately benefiting a charitable cause. In this method, you transfer assets to the CRT. The trust, in turn, pays income to one or more non-charitable beneficiaries (such as yourself or family members) for a defined term or for life. Once the term ends or upon the death of the income beneficiaries, the remaining assets will be donated to your designated charitable organization.
Because the CRT is a tax-exempt entity, it may sell appreciated assets without immediate capital gains recognition. However, distributions to beneficiaries are taxable under a four-tier system, often including ordinary income and capital gains components. Additionally, the donor typically receives an immediate charitable income tax deduction based on the present value of the remainder interest passing to charity.
CRTs involve long-term commitment, legal structuring, and IRS compliance. As such, they are best suited for individuals seeking both tax deferral and charitable impact.
Paying your capital gains taxes after a property sale can materially impact the net proceeds from the sale of an investment property. Fortunately, there are various strategies you can leverage to defer or delay these payments. Whether you’re considering 1031 exchanges, retirement accounts, or CRTs, make sure to do your research and consult with tax experts to find the option that works best for your investment goals.
The tax and estate planning information offered by the advisor is general in nature. It is provided for informational purposes only and should not be construed as legal or tax advice. Always consult an attorney or tax professional regarding your specific legal or tax situation.
Article written by: Story Amplify. Story Amplify is a marketing agency that offers services such as copywriting across industries, including financial services, real estate investment services, and miscellaneous small businesses.
Sources:
https://smartasset.com/taxes/section-121-exclusion
https://www.investopedia.com/terms/c/charitableremaindertrust.asp
https://www.investopedia.com/terms/s/section1031.asp
https://www.nerdwallet.com/article/taxes/capital-gains-tax-rates