Recently, I provided an expansive look at real estate investing. I detailed why you should invest, when to do so, and how to pay for it. With today’s article, I’d like to take that a step further and show you how to maximize your return on investment by explaining how to minimize your taxes when selling real estate investment properties. There are a lot of different ways to reduce your tax bill but by the end of this blog entry, you will be able to sell with confidence, knowing the most effective and legal ways of mitigating your tax burden. So join me as I make selling your real estate investments financially simple!
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Up to now, we have discussed the myriad of ways to invest in real estate but now it’s time to sell our investment properties. As with most cases, if you earn money, you need to pay taxes. I don’t know about you, but I like to keep the money I’ve earned. That’s why I take advantage of every legal tax deduction I have available to me. The goal is to keep my money and to give the government only what is absolutely necessary. Yet again I ask you to run this information by your CPA. They provide advice on if these ideas fit your specific situation.
Since we’ve been dealing with investing, let’s clear one thing up. I do not consider your personal residence an investment. Why? It’s simple, really. You would need a place to live whether you’re investing or not. That’s it. Your personal residence is simply fulfilling one of your basic human needs and, therefore, doesn’t count as an investment. You didn’t purchase it thinking that it would be a source of income for you. It was purchased to provide you and your family with shelter from the elements.
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However, if you live in the home for at least two of the previous five years, you can reap a tax benefit from the sale of your home. A single individual can claim a tax deduction of up to $250,000 on the profits from the sale of their home. Married couples can claim up to $500,000 in deductions. So even if you didn’t technically invest in the real estate market, there are still massive tax breaks available to you, as a homeowner, when you sell.
If you have any kind of investment savvy, you have likely heard of the 1031 exchange, also known as a Starker exchange or a like-kind exchange. Essentially, this is a powerful tax-deferment strategy in which we exchange one piece of property for another. Some of the most successful investors use this strategy.
The exchange gets its name from the tax code that defines it. Section 1031 of the IRS code allows an investor to defer paying capital gains taxes on an investment property when it is sold, as long another “like-kind property” is purchased with the profit gained from selling the first real estate property.
There are four basic types of exchanges and each can be utilized to great benefit if employed in the proper context. Let’s take a look at each one and determine when and how to use them to gain their maximum benefit.
Simultaneous exchanges take place when we sell one property and purchase another on the same day. In order for this to work, the transactions must take place at the same time or else the transaction can be disqualified and may face the full and immediate application of taxes. There are three basic ways that a simultaneous exchange can occur.
The delayed exchange is the most commonly used exchange and it does exactly what the name implies. I can sell a property today, hold the proceeds through an intermediary, and then purchase another property at a later date. In other words, the property the Exchangor owns, which is called the “relinquished” property, is transferred first and the property the Exchangor wishes to exchange it for the “replacement” property is acquired second.
Now, to use delayed exchange, you’re required to market your property, secure the buyer, and execute the sale and purchase agreement before it is initiated. Once you’ve done all of this, you must hire a third-party exchange intermediary to initiate the sale of the relinquished property. The intermediary will then hold the proceeds from the sale in a binding trust for up to 180 days while you acquire a like-kind property.
If you use the delayed exchange strategy, you have a maximum of 45 days to choose your replacement property and a total of 180 days to complete the sale of your original property. The length of this timeframe is one of the reasons that a delayed exchange is so attractive to investors.
Also known as forward exchanges, reverse exchanges occur when you acquire a replacement property through an exchange accommodation titleholder before you identify the replacement property. Now, some of you just read that and are saying, “Justin, hold up! Run that by me one more time.” It seems backward but that’s why it’s called a reverse exchange. You buy first and pay later, much in the same way purchasing with a credit card works.
These can be a little tricky because they require all cash. Furthermore, most banks will not offer loans for reverse exchanges. The reverse exchange follows a lot of the same rules as the delayed exchange but there are a few key differences. For one, taxpayers have 45 days to decide which property they are selling. After that 45 day period, they have 135 days to complete the sale and close out the exchange with the purchase of a replacement property. Failure to meet this 180-day deadline results in a forfeiture of the exchange.
This one is not as common as the others but it’s kind of cool. Basically, this exchange allows us to use our tax-deferred dollars to enhance or improve the property while it is in the hands of the intermediary. We are still bound to the 180-day window as well as a few key requirements.
The entire exchange equity must be spent on completed improvements or as a down payment by the end of the 180 days. We must also receive “substantially the same property” that we identified at the end of the first 45 days. Lastly, the replacement property must be equal or greater in value when it is deeded back to the taxpayer. The improvements must be in place before the taxpayer can take the title back from the qualified intermediary.
So now that we have detailed the four types of exchanges, let’s shift our focus to the seven rules that are attached to 1031 exchanges. These rules are important and failure to follow them will bring on some negative tax consequences. For our own edification, I’ve included them below.
To qualify as a 1031 exchange, the property being sold and the property being acquired must be “like-kind.” What does this really mean? By definition, “like-kind property” is a very broad term which means that both the original and replacement properties must be of “the same nature or character, even if they differ in grade or quality.” In other words, you can’t exchange your collection of baseball cards for a townhouse.
A 1031 exchange is only applicable for investment or business property, not personal property. Basically meaning, you can’t swap investment property for one primary residence. For example, if you moved from Florida to Tennessee, you could not exchange your investment property in Florida for a primary residence in Tennessee. Likewise, if you were to get married, and move into the home of your partner, you could not exchange your current primary residence for a vacation property. However, if you were to own a single-family rental property in Idaho, you could exchange it for a commercial rental property in Vermont.
In order to completely avoid paying any taxes upon the sale of your property, the IRS requires the net market value and equity of the property purchased must be the same as, or greater than the property sold. Otherwise, you will not be able to defer 100% of the tax. Now, this can be a single property that is equal in value to the relinquished property or it could be multiple properties that — in total — equal the value of your original. What matters is that you’re exchanging for equal or greater value.
A taxpayer must not receive “boot” in order for the exchange to be completely tax-free. Any boot received is taxable to the extent of the gain realized on the exchange. In other words, you can carry out a partial 1031 exchange, in which the new property is of lesser value, but this will not be 100% tax-free. The boot is the difference for which a seller will pay capital gains taxes. An example of this would be if your original property is sold for $2,000,000 and the property you wish to exchange under section 1031 is worth $1,500,000, you would need to pay the normal capital gains tax on the $500,000 “boot.”
The tax return — and name appearing on the title of the property being sold — must be the same as the tax return and titleholder that buys the new property. However, an exception to this rule occurs in the case of a Single-Member Limited Liability Company (“SMLLC”). This is because it is considered a pass-through to the member. Therefore, the SMLLC may sell the original property, and that sole member may purchase the new property in their individual name.
The property owner has 45 calendar days, post-closing of the first property, to identify up to three potential like-kind properties. This can be really difficult because the deals still need to make sense from a cash perspective. This is true especially in today’s market because people tend to overprice their properties when there are low-interest rates. So finding all the properties you need can be a challenge.
This rule has an exception known as the 200% rule. It allows you to identify four or more properties as long as their combined value doesn’t exceed 200% of the value of the property sold.
You must receive the replacement property and complete the exchange within 180 days. The exception to this rule is if the due date of the income tax return (with extensions) for the tax year in which the relinquished property was sold, is earlier than the end of the 180-day window. Any failure to meet this deadline will result in taxes.
If I’m being perfectly honest, I am not always a fan of the 1031 exchange. I know, I just spent all of this effort going through the ins and outs of the various types of exchanges just to say, I don’t really care for them. However, I have good reasons for feeling the way I do about them.
First of all, we are often required to invest all of our proceeds. We can’t simply say, “I made $50,000 in gains. I think I will reinvest that amount.” With a 1031 exchange, many times, we are required to reinvest all of the proceeds. This causes us to kick the proverbial tax can to a later date. What that means, is we could find ourselves in a much higher tax bracket when Uncle Sam comes to collect his dues. Finally, using a 1031 exchange alters the way we invest because we are bound to invest all proceeds and we’re still trying to avoid paying taxes.
If it doesn’t make sense, don’t do it. It is far better to pay a small amount of taxes now than to find ourselves buried in bad investments and owing an arm and a leg to the government. There are times when an exchange is useful, but be aware of the dangers of using one.
In 2017 the tax overhaul bill got quite a bit of attention because of its changes to the tax treatment of real estate. However, the Investing in Opportunity Act went largely unnoticed, at first. What this act did was establish Opportunity Zones (O-Zones). Opportunity Funds soon followed this designation of the O-Zones.
Opportunity zones are areas that are mostly made up of economically distressed communities that qualify for the O-Zone designation outlined in the 2017 Tax Cuts and Jobs Act. These zones exist in all fifty states and in the U.S. controlled territories of American Samoa, Guam, Northern Marina Islands, Puerto Rico, and the Virgin Islands. In fact, all of Puerto Rico falls into an Opportunity Zone.
Up to 25% of low-income neighborhoods that meet the income qualifications of the program in each territory can be designated as O-Zones. Meanwhile, up to 5% of non-low income tracts that meet other income and geographic requirements can be designated. In territories with less than 100 census tracts, up to 25 percent of census tracts can be designated as O-Zones. Areas certified as Opportunity Zones retain their designation for ten years. More than 8,700 qualified O-Zones have already been designated in the U.S. and its territories.
Now that we understand what O-Zones are, let’s take a closer look at the advantages of investing in them. When we sell our real estate investments, often times we will take 100% of the proceeds and reinvest it into another property. Folks, this is the tail wagging the dog, in my opinion. Rather than attempting to avoid the capital gains tax with this strategy, we could be receiving a huge tax benefit by taking advantage of Opportunity Funds.
When we divest an appreciated asset (stocks, bonds, real estate, etc…), we realize a capital gain which is a taxable event. However, if we reinvest the gains from our real estate sale into an opportunity fund we can defer and reduce our tax liability on that gain. Even better, we can receive tax-free treatment for all future appreciation earned through the fund.
If we invest our capital gains into a qualified opportunity fund, the tax liability for those earnings can be deferred until April of 2027 on investments held through December 31, 2026. Now, the gains must be invested in a qualified fund within 180 days in order to qualify for any tax treatment available under opportunity funds.
If we hold our opportunity fund investments for at least five years prior to December 31, 2026, we can reduce our liability on the deferred gain principal by 10%. That benefit increases to 15% if we hold the investment for at least seven years. This means that by investing in an opportunity fund today and holding it until New Year’s Eve in 2026, we can gain a 15% reduction. However, if we hold our investment for ten years, we actually become exempt from the capital gains tax on this investment.
There is a timeline that investors must follow in order to receive the maximum benefit available to them through O-Zones. For all who invested in 2019, there are some pretty important milestones between 2024 and 2029.
I have a client who sold a multi-family apartment complex a few years ago. Upon selling his property, he walked away with $250K in capital gains. If he had taken the gains from his divestment and placed them into an opportunity zone fund which we will say, hypothetically, doubled over the course of a decade. That means that his original $250,000 Investment is now worth a hypothetical $500,000.
Because he held the investment for ten years, he doesn’t owe taxes on the appreciation. Sure, he still owes capital gains taxes on the original investment but he saved thousands of dollars in taxes by deferring the gains for ten years. Now, I want you to understand that I am really watering down a very complex subject here for the sake of introducing it to you. I recommend speaking with a tax professional if you’re thinking of using this strategy but it is available to you.
My friends, Fred and Wilma, are a typical middle-aged couple who have invested in real estate. They have about $200,000 in their real estate portfolio and they’re ready to sell all of their property. They could look at a 1031 exchange but they’re ready to retire. Together, they want to travel the world and enjoy their golden years. They could transfer their gains into an opportunity fund and waiting for their return in ten years.
Wilma owns her own business and earns around $180,000 annually. With self-employment taxes, income taxes, and capital gains taxes, Fred and Wilma are facing $92,000 dollars in tax liabilities. But what if there were a way for them to walk away from real estate entirely AND reduce their tax liability? With comprehensive tax planning, they can!
Because they’re each over fifty years old, they can put away $25,000 each into a solo(k). On top of that, they can put 20% of the $180,000 into the solo(k) as a profit-sharing contribution from the company. Next, Fred and Wilma open a health savings account and utilize some “bunching” (you pay all of your medical expenses and other Schedule A expenses in one year). After this, they decide to donate some of their money to charity. With all of these write-offs, Fred and Wilma have suddenly lowered their tax bill to $22,000. That’s $70,000 that they aren’t paying to Uncle Sam.
If you’re investing in real estate, it is really helpful to seek the counsel of a tax professional. There are so many ways to mitigate your tax burden but if not done correctly, it’s really easy to make things worse. These are just a few of the tax deferral strategies that are available to you and what works for some may not always be the best course for others. But with a little knowledge and the guidance of an expert tax professional, minimizing your taxes when selling real estate can be financially simple.