Is it possible to truly avoid capital gains tax? If, by avoid, you mean defer and reduce, then the answer is a definite yes. If structured correctly, some capital gains can completely avoid taxes. At some point, the IRS will come looking for their share. When the time comes, there are a few ways to hand over less and, in some cases, none at all. Here are five of them.
A 1031 Exchange is named after the 1031 IRS code section. It allows you to sell an investment property and use the proceeds to buy a new property of like-kind. Basically, that means a new investment property of equal or greater value. The basis from the relinquished property in a 1031 is carried over into the replacement property. The catch is that the replacement property must be identified within 45 days of closing the relinquished property and needs to be closed within 180 days. You must also use the same entity throughout the process (i.e., individual, LLC, etc.).
A 1031 is specific to investment properties. Meaning, a property “used in a trade or business or held for investment.” You can’t 1031 your primary residence for another primary residence. For tax avoidance on a primary residence, check IRS code section 121. It states that the property (i.e., primary residence) must have been held for two of the last five years. Those meeting this requirement are able to exclude $250,000 of gains, if filing single, and $500,000, if married filing jointly.
Qualified Opportunity Zone (QOZ) Investment
With a QOZ investment, your gain must be invested within 180 days from the date of sale of the capital asset. If this sounds familiar, that’s because it is similar to the 1031 exchange 180-day rule, but Qualified Opportunity Zone investments do not have the same 45-day identification rule. The primary difference between the two transactions, however, is that only the gain needs to be reinvested in the QOZ investment - meaning your principal can be pocketed on a tax-deferred basis. Eligible capital gains are defined in IRS section 1400Z-2. These gains include:
- Gains from stocks and sale of a business.
- Section 1231 gains.
- Short-term and long-term capital gains.
As you may know, any gain reinvested into a QOZ before December 31, 2021, may be deferred until 2026 with a potential 10% reduction to the original taxes owed. Although this deferral opportunity is attractive, perhaps the most attractive aspect of a QOZ investment is the ability to receive a full step-up in basis upon liquidation of the fund. This means investors will not be liable for taxes on any gain derived from the fund itself (if the investment is held in the fund for at least 10 years).
Tax-loss harvesting is a term used for offsetting capital gains with losses. The basic idea is to sell losing positions against winners, reducing the total taxable gain. For example, if you have an unrealized $2,000 loss and a realized $5,000 gain, you can realize the loss and offset the gain. The result is a $3,000 gain, reducing your taxable gain by $2,000. Tax-loss harvesting can be used with both short-term and long-term gains.
Per the IRS, short-term and long-term losses must first be used to offset gains of the same type. If losses of one type exceed the gains of that same type in any given year, however, they can be used to offset the other type of gain. Also, the tax code allows you to use up to $3,000 in capital losses in a year to reduce ordinary income. If your losses exceed gains and you’ve utilized the $3,000 reduction on ordinary income, any remaining losses may be carried forward to future years.
Investing Through Qualified Accounts
A qualified retirement plan meets the IRS Section 401(a) for tax-deferment. These plans are available to employees through their employer. Most likely, you’ve come across these plans and probably even have one or two. They include 401(k)s, 403(b)s, and HSAs. Money invested in these plans is taken out of the employee’s paycheck pre-tax. When money is withdrawn (during retirement), taxes must be paid. This includes both the principal and the growth.
The above retirement plans form a group called defined-contribution plans. These are not to be confused with less common pension plans or annuities. Defined-contribution plans can either be self-managed or managed through a financial advisor.
Defined-contribution plans allow investors to defer taxes into retirement. If the investor’s tax rate is lower during retirement than at the time of contribution, they will pay less in taxes upon withdrawal than if they had paid those taxes during their working years.
Note that a defined-contribution plan is not the same as a traditional IRA or Roth IRA, although the two mimic a lot of the same tax incentives as a defined-contribution plan. While traditional IRA contributions are tax-deductible in the year they are made, similar to a 401(k), a Roth IRA allows you to withdraw funds from your account tax-free in retirement.
Proper Estate Planning
Leaving your estate to your heirs will be part of your legacy. But you don’t want your legacy to generate a huge tax bill for your heirs, leaving them with a surprising burden. With proper estate planning, your heirs can take advantage of a step-up in basis. This means that upon your passing, they inherit your estate at the current market value rather than your basis. If your heirs decide they want to sell some of the estate immediately, they will likely have a very small tax bill, if any at all.
As an investor, you try to do everything you can to avoid paying the full price for a property. It shouldn’t be any different with your taxes. We’ve looked at five different tax strategies that can help you defer, reduce, and even avoid taxes. Adding these strategies to your investment toolbox can help to increase your income through smart tax strategies.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions.
Realized does not offer legal or tax advice. As such, this information should not be used as a substitute for consultation with professional accounting, tax, legal or other competent advisers. Before making any decision or taking any action, you should consult with a qualified professional.
There are material risks associated with investing in real estate securities including liquidity, tenant vacancies, general market conditions and competition, lack of operating history, interest rate risks, the risk of new supply coming to market and softening rental rates, general risks of owning/operating commercial and multifamily properties, short term leases associated with multi-family properties, financing risks, potential adverse tax consequences, general economic risks, development risks, long hold periods, and potential loss of the entire investment principal. Past performance is not a guarantee of future results. Potential cash flow, returns and appreciation are not guaranteed. IRC Section 1031 is a complex tax concept; consult your legal or tax professional regarding the specifics of your particular situation. This is not a solicitation or an offer to sell any securities.