As any real estate investor with years in the game will tell you, every penny counts when you're making a deal. And one of the biggest traps newer investors fall into when selling properties is not taking into account capital gains tax.
Capital gains tax is the tax you pay on the profit you make when you sell an asset, like a house, for more than you bought it for. So if you buy a property for $450,000 and sell it for $650,000 - you’re taxed on that $200,000 “capital gain”.
Paying some taxes is inevitable, but capital gains tax doesn't have to hurt your ROI too much. Here are five ways to avoid paying capital gains tax when selling real estate:
Hack #1: Hold Onto The Property For Over 1 Year
Holding on to a property for at least a year before selling it is one of the easiest ways to lower your capital gains tax bill. With this plan, you can qualify for the long-term capital gains tax rate, which is usually lower than the short-term rate.
Long-term capital gains tax rates can be as low as 0% for people in the 10% or 12% tax brackets and 15% for people in the 22% to 35% tax brackets. It goes up from there, but the bottom line is you can keep more of your profits if you keep the property for more than a year.
Hack #2: Leverage A 1031 Exchange
A 1031 exchange is a tax-deferred exchange that lets you swap one investment property for another without having to pay the capital gains tax on the sale of the first property upon sale. To be eligible for a 1031 exchange, the properties must be "of like-kind." This means that they are of the same kind, even if they are of different grades or qualities. For example, if you sell a residential property, in order to be eligible for a 1031 exchange, you need to buy a residential property.
This strategy can help you avoid paying capital gains tax when you sell a property, so you can put the money from the sale toward another property and keep building your portfolio.
Hack #3: Maximize Depreciation Deductions
Depreciation is when the value of an asset slowly goes down over time. Investors in real estate can use depreciation to offset their taxable income and pay less tax. By taking as many depreciation deductions as possible, you can lower your taxable income and, in the end, your capital gains tax bill.
But it's important to remember that the depreciation recapture tax may apply when you sell the property. This means that you may have to pay back some of the depreciation deductions you've taken. You should consult a real estate expert to help you maximize your depreciation deductions.
Hack #4: Invest in Qualified Opportunity Zones
Qualified Opportunity Zones (QOZs) are areas in low-income areas that are set aside for real estate investors and offer tax breaks. By investing in a QOZ, you can put off paying capital gains tax on the sale of your first investment until December 31, 2026, or until you sell your QOZ investment, whichever comes first. If you keep your investment in QOZ for at least ten years, you can avoid paying federal capital gains tax.
Hack #5: Invest In A State Without State Capital Gains Taxes
Investing in a state with no state capital gains tax is another way to avoid paying capital gains tax on real estate deals. Capital gains tax is collected by the federal government, but some states don't have their own.
2 . Florida
3. New Hampshire
5. South Dakota
If you’re serious about growing your real estate investing business, learning the tips and tricks to avoid capital gains tax is absolutely critical. Another mission critical item? Real estate investing software like Realeflow. Grab your 7-day free trial of Realeflow here!