After selling a house, you may be feeling optimistic about the profit you’ve just made. There are many investment opportunities on the horizon, and you’re planning to use all of the home sale proceeds for promising prospects. Unfortunately, there is still one more thing that you’ll need to address before you can start investing: capital gains taxes.
The IRS imposes regulations that require property owners to pay a type of income tax from the profits of a home sale. Capital gains taxes may seem like a small nuisance, but the rates are high enough that you could end up paying hundreds of thousands of dollars if you’re in the higher tax brackets. As such, many investors implement strategies that help reduce and possibly eliminate capital gains taxes.
In this blog post, Realized 1031 dives deeper into these approaches to help investors understand their options. This way, you can begin considering your choices before you start selling your real estate assets. Keep reading to learn more.
Understanding Capital Gains: Why Do You Need to Pay Taxes?
Capital gains are the profit you gain from selling a property at a higher value than the original sale price or cost basis. For example, if you bought a property five years ago for $500,000 and sold it for $1 million today, your capital gain is $500,000. The proceeds are, of course, a form of income. As such, you’re compelled to pay capital gains taxes within the tax year of the sale. Failure to do so will result in penalties.
Capital gains taxes are different from regular, ordinary income. The tax brackets are lower on a federal level, with the maximum being 20% in most cases. There are rates higher for other types of assets, but for real estate properties, 20% is the maximum. In our example above, the capital gains is $500,000. Assuming that you’re in the top tax bracket, you will end up paying around $100,000 in capital gains taxes. That’s a huge amount — funds that could be used for other investments or personal use. As such, many investors follow strategies that help minimize, defer, or remove their tax liabilities.
Ways To Minimize or Eliminate Capital Gains Taxes
Capital gains taxes can consume a substantial portion of your home sale profits. Thankfully, there are plenty of strategies you can employ to potentially reduce tax liability and keep a bigger amount from your home sale.
1. Holding the Property for a Longer Period
There are two types of capital gains, short-term and long-term capital gains. The first one is for any type of asset you hold for a short period — less than a year. The IRS charges higher rates for these properties because short-term capital gains are considered ordinary income. As such, an investor in the highest tax bracket may need to pay up to 25% of the capital gains.
On the other hand, a long-term capital gain is the profit from an asset you held for more than a year. The IRS categorizes these proceeds into another group: capital gains taxes. These profits are then taxed from 0 – 20% maximum.
The rates for long-term capital gains are lower because the IRS wants investors to hold on longer to their real estate assets. Otherwise, various markets could experience volatility that could result in economic instability.
Given the different rates for short and long-term capital gains, it may make for investors to hold on to assets for longer to potentially reduce the capital gains tax on home sale gain. In our example above, you could end up saving up to $25,000 if you’re in the highest tax bracket.
2. Home Selling Tax Exemption
For homes, there is a way to avoid paying capital gains taxes altogether up to a certain point. This perk is called the capital gains exclusion for primary residences, or the Section 121 Exclusion. This exemption benefits both single and married homeowners. For the former, the IRS exempts you from paying capital gains taxes up to $250,000 in home sale profits. The same applies to married taxpayers, but the limit is $500,000.
Of course, the IRS has strict guidelines on what constitutes a primary residence. These are the three main ones.
- You must have lived in the home for at least two years in the past five years. The years don’t have to be consecutive.
- You must have owned the home for at least two years in the past five years.
- You must not have taken any type of capital gains tax exemption in the past two years for another primary residence.
While the Section 121 exemption is helpful for homeowners, investors owning other types of properties will not always be qualified for this strategy. Thankfully, there are other methods of reinvesting capital gains to avoid taxes. We’ll discuss these further to help you understand how to defer capital gains tax on primary residences and other types of assets.
Tax Loss Harvesting
Another method that could potentially lower your tax liability for capital gains is tax loss harvesting, specifically netting and carryover losses. This happens when you offset your capital gains taxes using your losses from the current tax year. A more deliberate method is selling securities, like bonds or stocks, at a loss to minimize capital gains taxes.
Let’s say that in a year, you sold a property and gained $500,000. However, some of your other assets, like the shares of a company, were sold at a loss that totaled $300,000. If you include these in your tax filing, you end up paying taxes for only $200,000 in capital gains.
Gifting the Assets
Another way to potentially eliminate capital gains taxes is by gifting the assets to your chosen beneficiaries. This practice is common during estate planning, especially for investors who want to stay in control of their assets after their passing. When gifting an asset, no sale occurs. In other words, there is no taxable event. As such, the beneficiary assumes the cost basis of the real estate property and will only need to pay capital gains taxes when they sell the home themselves.
For heirs who receive a real estate asset after the death of a loved one, the capital gains taxes may be eliminated entirely. This is because the asset has now undergone a step-up in basis. In short, the original price resets to the current value of the property. If the heir decides to sell the asset before it appreciates, then they didn’t technically gain any profit, even if the previous owner had.
Alternative Investment Options
Another method to potentially avoid taxes on home sales is by trying alternative investment methods. In a traditional setup, you sell your home and use the proceeds from the sale to purchase another investment property. This scenario creates a taxable event and causes you to lose a significant portion of your earnings.
Alternative investment options like 1031 exchanges, Delaware Statutory Trusts (DSTs), and Opportunity Zone programs help defer or even eliminate tax liability. These methods delay a taxable event from occurring, allowing you to hold on to your capital gains for longer so it can grow. Once you finally sell the property, only then will you have a tax liability.
1031 Exchange
One of the primary options for investors who want to defer their capital gains taxes is a 1031 exchange. This process is named after Section 1031 of the IRS Code. This is also called the like-kind swap, which allows an investor to exchange a property for another without a sale occurring.
1031 exchanges are not easy to pull off. The IRS has a lot of strict rules regarding such processes to avoid abuse or fraud. As such, those who choose this route should consult with experts like us at Realized 1031. We’re your experienced professionals who can help you execute an exchange that qualifies you for the tax deferral benefits.
How 1031 Exchanges Defer Capital Gains Taxes
In a 1031 exchange, no sale occurs. This is the triggering event that makes you liable to pay taxes. Instead, you’re merely swapping properties. A home sale will still happen, and you will still need to acquire a new property. However, the entire transaction will happen through a qualified intermediary. As such, investors remain at arm’s length throughout the entire process and avoid making a constructive receipt.
Other rules involved in 1031 exchanges are the following.
- Like-kind Requirement: You cannot exchange a primary residence for an investment property. The IRS requires all 1031 exchanges to happen between similar types of properties, especially investment properties. As such, you can exchange apartment buildings for a commercial property that leases units to businesses.
- 180-Day Rule: The entirety of the 1031 exchange process must happen within the 180 days allotted by the IRS. This time limit may make the swap harder for investors, especially if they can’t find a property that satisfies the like-kind requirement.
- Equal or Greater Value Requirement: You cannot exchange a property for another of lesser value. Otherwise, the IRS will recognize the remaining value as capital gains and disqualify you from the tax deferral benefits. You will need to exchange with a property that’s of equal or greater value than the home you’re about to relinquish.
The 1031 Exchange Process
The 1031 exchange process is intricate. Here’s what to expect if you plan to avoid capital gains tax by reinvesting through this method.
- Engaging With a Qualified Intermediary: You will need to work with a qualified intermediary or accommodator. This entity will supervise the entire transaction to ensure that you’re following the right steps and aren’t committing mistakes that could result in disqualification. Plus, the intermediary will be the one to handle the funds during the sale to avoid constructive receipt.
- Identification of Like-Kind Properties: While this step technically isn’t required until after you sell, it is recommended to start before you sell. Then, once you sell the relinquished property, the 180-day timeframe begins. Within this deadline is another 45-day identification period. This step requires you to select up to three potential properties. You will also need to submit the details of these properties as proof that you’ve found acceptable replacements.
- Selling the Property: After you’ve chosen your qualified intermediary, the next step is to relinquish your current property during a home sale. At this point, you may want to work with a real estate agent for the marketing, listing, closing, and other steps involved in a real estate sale.
- Acquisition: After the identification period comes the purchase of the identified property. The qualified intermediary will hand over the funds to the property seller of the acquired property to prevent constructive receipt. After closing, the exchange process is officially over. You will need to notify your tax advisor so they can properly accomplish the forms and avoid errors or delays that could result in penalties.
Advantages and Disadvantages of 1031 Exchanges
When completed correctly, 1031 exchanges offer an array of benefits for homeowners. Here are some of the pros of this alternative investment.
- Tax Deferral: Like-kind exchanges allow investors to defer capital gains taxes indefinitely. So long as you keep exchanging property for a similar one, you can theoretically continue delaying your tax obligations while you continue growing your capital.
- Flexibility: 1031 exchanges allow you to adjust your market holdings based on market conditions and other factors — all while avoiding the tax liability that comes with the sale of an appreciated asset.
- Diversification of Assets: The like-kind requirement is flexible enough that you could exchange your current investment property for another one in various markets or geographical locations. This benefit provides you with more opportunities to create a diverse portfolio, providing additional protection against volatile markets.
- Estate Planning: Properties under a 1031 exchange that will eventually pass on to heirs may step up in basis at the death of the original owner. This process effectively resets the original purchase price of the property. If the heir decides to sell the property before it appreciates, then they won’t pay any capital gains taxes.
If there are advantages to 1031 exchanges, there are also possible risks that investors must consider and avoid. Here are some of the common disadvantages.
- Intricate Process: The IRS has many rules regarding a 1031 exchange process to ensure the tax deferral status of investors. If you fail to follow or satisfy any of these requirements, such as working with a qualified intermediary who has a personal or professional relationship with you, you can get disqualified.
- Short Timeline: The 180-day deadline may seem like a long time, but it can be too quick for many investors. It’s not easy to find a property that has the same value as the one they’re about to relinquish. If an investor does find one that has a greater value, they may need to shell out cash or take a loan to have enough to purchase the property.
- No Access to Your Capital: Since the funds from the sale of the relinquished real estate asset go to your qualified intermediary, you won’t have access to it. If you do take out a portion, you will trigger a taxable event and will be required to pay capital gains taxes.
These are just a few highlighted advantages and disadvantages an investor and home seller must consider.
Delaware Statutory Trusts
Delaware Statutory Trusts (DSTs) are another tax-advantaged investment method that works differently from 1031 Exchanges. In actuality, DSTs are intertwined with 1031 exchanges, popularly used as an alternative to traditional 1031 exchanges because of several advantages. Since the IRS recognized DSTs as an acceptable method for accessing like-kind properties through a 1031 exchange, such an arrangement has become a viable method for even small-time investors.
In a DST, the investor doesn’t exchange properties. Instead, they buy fractional interest of the trust, which is the actual owner of the commercial or investment property. Through this investment vehicle, no purchase actually occurs. Since the investor only exchanged the relinquished property for shares on the trust, they don’t incur any tax liability.
How Do DSTs Work?
A DST process follows the same first steps as a 1031 exchange. However, the process starts to diverge during the identification period. Instead of finding a like-kind property, the investor finds a broker that can find DST sponsors. The DST sponsor is the entity that owns the DST and makes offers through these brokers.
Once the investor has chosen a property through the broker, the qualified intermediary will transfer the funds to the sponsor. Again, the investor cannot hold the proceeds themselves to avoid creating a constructive receipt.
The sponsor will wait until the pooled money from the DST investors can finally be enough to cover the initial capital the sponsor used to purchase the DST property. At this point, the sponsor turns over ownership of the trust to the investors. The former will still handle daily operations and management while paying the investors the earnings of the investment property on a regular basis.
Pros and Cons of DSTs
DSTs have their own set of advantages and disadvantages. Understanding these considerations is important if you want to learn how to avoid capital gains when selling a house through this method.
Advantages
- Tax Deferral: Since DSTs are a 1031 exchange vehicle, investors enjoy the same tax deferral benefits. You won’t need to pay any capital gains taxes until you trigger a taxable event, such as selling the shares after the DST’s holding period.
- No Need to Match Value: So long as you meet the sponsor’s set minimum for the DST, then you won’t need to find a property that matches the value of the relinquished home. Even so, the IRS will still require you to use all the proceeds from the relinquished property in the DST.
- Hands-off Involvement: DSTs are ideal for investors who no longer want to deal with the daily operations of an investment property. The sponsor will take over this aspect through a property manager.
- Access to Institutional-Grade Assets: These types of assets are ones that are valuable enough to attract national and foreign investors. Since investors are pooling their money, they could purchase such an asset and potentially enjoy higher income.
Disadvantages
- Long-holding Period: DSTs are subject to longer holding periods, which leave you unable to sell or do anything else with your assets for 10 to 15 years, in most cases. This illiquidity may make it harder for you to access the funds in case better investment opportunities present themselves.
- High Fees: The sponsor will still take a percentage of the investment property’s income as payment for the administration and management of the asset. The amount can be high, leaving a smaller amount for investors. Even so, this disadvantage is a given since DSTs offer hands-off involvement for investors.
- Lack of Control Over Operational Decisions: As we mentioned, the sponsor often has complete control over the investment property in a DST. You don’t have a say over capital improvements, which property manager to choose, and other types of decisions that could potentially, in your eyes, increase the income of the investment property.
These are just some of the pros and cons of a DST. You should get familiar with all of them before you make a decision.
Opportunity Zones
Aside from 1031 exchanges and DSTs, investors can also take advantage of the Opportunity Zone program to defer and potentially eliminate their tax liability after a home sale. Born from the Tax Cuts and Jobs Act of 2017, this program designates certain areas across the US states and territories that are experiencing economic hardships. Thanks to the funds from private investors, the Opportunity Zones can gain the resources to create jobs, build infrastructure, and spur economic development.
In exchange for investing in an Opportunity Zone, investors enjoy benefits like tax deferrals. If they manage to hold on to the property during the 10-year holding period, then all the capital gains of the previous property and the appreciation of the current one will reset through a step-up in basis. This benefit essentially eliminates your tax liability.
How Opportunity Zones Work
Investing in an Opportunity Zone property using funds from a home sale works similarly to a 1031 exchange or DST.
- Find a Sponsor: You will need to engage with a private equity firm or an Opportunity Zone sponsor to join the Qualified Opportunity Fund or QOF. This entity will be the one handling the administrative aspects of the property. As soon as the sponsor pools enough funds, they will purchase the property and begin the substantial improvement requirements. The IRS has also placed a 180-day deadline for investors to find and join a sponsor. If you fail to follow this timeframe, you will get disqualified from the tax deferral benefits.
- Joining the QOF: Once you’ve found the sponsor, you join the QOF — the actual investment vehicle. Through this corporate-like structure, the investors and sponsors manage the property. The IRS requires the QOF to dedicate at least 90% of its assets to the Opportunity Zone property.
- Substantial Improvement Requirement: In general, sponsors will purchase a property that already exists in the Opportunity Zone. To qualify for the benefits, the IRS requires sponsors and investors to make substantial improvements to the property. In other words, the property must double in value within 30 months of acquisition.
- Tax Reporting: Upon entering the QOF and satisfying the requirements set by the IRS, the next step to take is reporting the tax deferral through Form 8949. Your initial capital will maintain its tax-deferred status until December 31, 2026, or until the sponsor sells the property.
Pros and Cons of Opportunity Zones
Investing in Opportunity Zones is both rewarding and complex. It’s important to learn about the advantages and disadvantages to better understand how to avoid capital gains tax on house sales through this approach.
Pros
- Tax Deferral: By investing in Opportunity Zones, you can potentially defer capital gains taxes from a home sale. There’s a possibility of eliminating all of it through the 10-year holding period’s step-up in basis.
- Spur Growth in Communities: On a more philanthropic note, joining a QOF gives you an opportunity to help disadvantaged communities, families, and individuals find economic stability.
- More Diverse Portfolio: Investing in Opportunity Zones is not limited to real estate properties. You can also join QOFs sponsoring businesses or infrastructure projects. This variety can improve the diversity of your portfolio and cushion you from the volatility of other markets.
- Active or Passive Role: Unlike DSTs, you can choose a sponsor that offers either a passive or active role over the operations of the property.
Cons
- May Be Riskier Than Other Alternative Investment Options: Since you’re investing in economically distressed areas, there’s a possibility of market volatility, leading to losses. You must carefully assess the projected market conditions of the geographical area you’re investing in to get a bigger picture and lower the chances of substantial losses.
- Community Resistance: In some cases, the communities from the designated Opportunity Zones may resist the development projects offered by the program. The primary reason is the danger of gentrification, making the area inaccessible to the original residents as the cost of living rises. Avoiding this scenario requires investors to regularly engage with members of the communities. That way, both parties can strike a balance.
- Crowded Exit: Upon the December 31, 2026 deadline, many investors may choose to leave their QOFs, leading to a crowded exit. As the rush surges, the value of the properties and other assets may go down significantly. Still, the likelihood of this scenario is low since many may wait for the 10-year holding period (2028 or 2029) to fully enjoy the step-up in basis.
These are just some of the pros and cons of an Opportunity Zone. You should get familiar with all of them before you make a decision.
Deferred Sales Trusts
There’s another DST that works differently from the first three: deferred sales trusts. This DST allows you to delay the payments through installment sales. You don’t pay a lump sum in capital gains taxes after selling the property. Instead, the trust pays the proceeds in increments, allowing you to potentially minimize your tax liability yearly.
This DST can be complex. As such, it’s important to work with qualified professionals to ensure water-tight contracts and the right process to maintain the installment sale status.
The DST Process
Here’s the general process you’ll need to follow if you intend to use deferred sales trusts to defer capital gains tax in a real estate sale.
- Creating the Trust: You work with your tax lawyer and your chosen trustee to set up the trust and ensure that it follows IRS regulations as well as other pertinent laws. This trust will be the entity that holds the proceeds from the home sale.
- Transferring the House to the Trust: Instead of selling the property to a buyer, you transfer its ownership to the trust. This step sets up the stage for the trust to eventually be the one selling your home to the final buyer.
- Trust Sells the Final Property Buyer: The trustee will find a buyer and sell the property, keeping the proceeds. Since you didn’t make the sale yourself, you’re not liable to pay capital gains taxes.
- Trust Manages the Proceeds: The trustee manages the proceeds from the sale, with some dedicated DST companies investing the money to increase your income. They should find investment opportunities that can help cover their fees while maintaining regular payments to you.
- You Receive Payments From the Trust and Pay Taxes: Based on the contract, you can receive payments monthly, quarterly, or yearly. These payments end the deferred status of the specific amount you receive, so you’ll need to report them as capital gains and pay your due taxes. As such, it’s important to outline the frequency of the payments based on how much you can realistically pay per tax year.
Advantages of Deferred Sales Trusts
- Tax Deferral: While this DST doesn’t eliminate capital gains taxes for home sales, you can still delay payments over time. This way, you can use the rest of your capital for other investments through the trustee.
- Flexibility: You’re in full control of the frequency of payments. Thanks to this flexibility, you can better predict how much you’re going to pay within a tax year.
- Diversified Portfolio: There’s no need to find like-kind properties in this DST. The trustee can choose any type of investment so long as it’s lucrative enough.
Disadvantages of Deferred Sales Trusts
- Complexity: Creating the trust is a complex legal process. You will need to work with qualified and trusted professionals to ensure accuracy and maintain the tax-deferred status.
- High Fees: Along with the complexity is the high cost of fees. The payments don’t end after setting up the trust or sale. The trustee will continue to charge payments to manage the proceeds.
These are just some of the advantages and disadvantages of a DST. You should get familiar with all of them before you make a decision.
Professionals To Work With When Trying To Minimize Capital Gains Taxes
The next step after learning the ways to potentially reduce capital gains taxes is to find professionals who can provide further details and help you begin the initial steps. Here are a few experts to work with.
- Tax Attorney: Your tax lawyer will handle most, if not all, of the legal process in the processes we outlined above, whether it’s gifting assets or using an alternative investment approach. Having them work with you helps ensure accuracy in all the processes involved.
- Financial Advisor: Financial advisors help you evaluate your investment goals and plan for short- and long-term investments. They have the resources to help you better understand the risks and rewards you can expect, whichever investment you choose.
- Alternative Investment Experts: If you want to invest in the alternative methods we discussed, we recommend working with experts like us at Realized 1031. We can provide guidance, advice, and tailored solutions to help ensure the easy creation and execution of your investment plans. Having us by your side helps give you the confidence that you’re accomplishing the right steps and increasing the chances of a successful investment.
Wrapping Up: How To Avoid Capital Gains Taxes When Selling a House
Even though there’s a promise of profits when selling an appreciated home, capital gains taxes leave a cloud that prevents you from fully enjoying all your proceeds. Thankfully, there are plenty of options you can use to delay or eliminate capital gains taxes altogether. From longer holding periods to gifting the asset, from using carryover losses to using alternative investment options, these approaches can help you manage your tax liability and keep your capital for other investment opportunities.
For more details about 1031 exchanges and similar alternative investment routes, we can help. Contact Realized 1031 today and let’s discuss your 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.
Sources:
https://www.investopedia.com/terms/c/capitalgain.asp
https://www.irs.gov/taxtopics/tc701
https://www.investopedia.com/terms/t/taxgainlossharvesting.asp
https://www.investopedia.com/taxes/trumps-tax-reform-plan-explained/
