Benjamin Franklin famously remarked, “In this world, nothing can be said to be certain, except death and taxes.”
That may be true for the average person, but not for real estate investors.
Curious how you can dodge the tax man’s grasping paws? Try these seven ideas to minimize taxes on real estate profits and cash flow.
Every real estate investor has heard of 1031 exchanges, so I won’t belabor them here. But they make a great diving board for jumping into other more creative ideas.
As a refresher, 1031 exchanges allow real estate investors to take the proceeds from selling one income property and put them toward a “like-kind” investment property.
Realtor Darren Robertson explains further: “A like-kind or 1031 exchange allows an investor to sell a property and defer paying capital gains taxes on the profit — if they reinvest the proceeds into another property of equal or greater value within certain time frames and following specific IRS rules. This strategy allows investors to continually roll over their gains from one property to another, potentially deferring taxes indefinitely until they eventually sell the property for cash.”
Like all tax rules, 1031 exchanges come with plenty of regulations and red tape. You have to declare the replacement property within 45 days of selling the old property and must settle on it within 180 days. And you have to pay a “qualified intermediary” to hold those funds for you in escrow — you can’t touch them yourself.
I’ve always found that to be too much hassle and cost. So, I opt for the easier, lazier cousin of the classic 1031 exchange.
When you first passively invest in a real estate syndication, you get a huge tax write-off for depreciation. That comes from two sources: accelerated depreciation from cost segregation, and bonus depreciation (created by the Tax Cuts and Jobs Act of 2017, which may or may not be extended).
On the flip side (pun intended), you get hit with a gnarly tax bill when a real estate syndication goes full cycle and sells. Those tax bills include both capital gains tax and depreciation recapture.
If you don’t have other sources of investment income, you can carry your initial on-paper losses forward to the time when the asset sells and you get your payday. But what if you already used those paper losses to offset other gains and passive income?
No sweat — you can just invest in a new real estate syndication. Use the tax write-off from the new investment to offset taxes on the old one.
Best of all, you don’t have to putz around with qualified intermediaries or strict timelines. You just have to invest in a new syndication within the same calendar year for the on-paper losses to offset your gains.
And no, you don’t need $50,000–$100,000 to invest in a new syndication. At least not if you split that load with other investors who you either know personally or as a member of a real estate investment club. Our Co-Investing Club at SparkRental gets together once or twice a month to vet different sponsors’ deals together, and each member can invest with $5,000 if they like.
Uncle Sam slaps you with capital gains tax when you sell an asset. But what if you never sell it?
If you own properties directly, you can simply leverage them, let your renters pay off your mortgage, and then refinance them to pull out your equity without selling.
You get your cash out, and you get to keep the asset. It keeps generating cash flow, appreciation, and tax benefits for you, and you can keep refinancing it every decade or so to keep pulling out equity.
When you kick the bucket, the cost basis resets, and your kids could inherit it with no capital gains taxes. But talk to your accountant about it first.
If you have a big taxable gain this year, you can of course offset it with losses on a different investment.
Those could be actual losses, but that’s not a lot of fun. For instance, maybe a deal goes sideways on you, or maybe you cut your losses on a bad stock pick.
Or you could use tax loss harvesting to simply swap out similar investments and take an on-paper loss.
Imagine you own shares in an exchange-traded fund (ETF) that owns small-cap U.S. stocks. It’s having a bad year, but you’re confident it will turn around sooner or later and want to keep it — or something similar to it — in your portfolio.
So, you sell your shares, and then immediately buy shares in a similar ETF, perhaps one that owns U.S. mid-cap stocks. Your portfolio remains relatively unchanged, but you get to show the tax losses from selling shares in the downtrodden ETF.
Pretty cool, right?
A Roth IRA lets your investments grow and compound tax-free, and you pay no taxes on withdrawals in retirement.
Sure, you can invest in public REITs with a brokerage Roth IRA. But if you want to buy properties directly, or invest in real estate syndications or real estate crowdfunding investments, you need to open a self-directed IRA.
That’s the good news. The bad news is that you have to pay a custodian an annual fee to oversee it for you. Also, if you want to buy a rental property directly, between financing wrinkles and headaches with moving money around, it can get complicated quickly.
Self-directed IRAs work well for syndications and crowdfunding, however. Many members of our Co-Investing Club invest $5,000 at a time in syndications using their self-directed Roth IRA.
If you want to avoid capital gains tax on hundreds of thousands of real estate gains, move into the property for two years.
“Homeowners don’t have to pay capital gains taxes on their first $250,000 in profits when they sell a primary residence,” explains Bill Gassett of Maximum Real Estate Exposure. “That number jumps up to $500,000 for married couples.
“You do have to meet the IRS requirements, though. Specifically, you must have lived in the property for at least two of the last five years.”
That means that if you move into a rental property for two years before you sell it, you can dodge capital gains taxes on it. Conversely, you could buy a home, move in for two years, move out, and keep it as a rental for the next three years, and sell it with no or low capital gains taxes.
Think you can’t have your cake and eat it, too, with the standard deduction and itemized deductions?
Real estate investors list their expenses on a separate schedule of their tax return from their personal deductions. That means you can deduct for expenses like a home office, travel, and meals related to your real estate investments — and still take the standard deduction. Consult with your accountant first, of course.
To win any game, you need to know the rules inside and out. And nowhere is that truer than in the game of money and building wealth.
When you understand the rules governing taxes on real estate and other investments, you can mix and match your approach. For example, if you take a big loss on an investment this year, maybe it’s a good year to do a Roth conversion to move money from a traditional IRA to a Roth IRA. Perhaps even a self-directed Roth IRA, where you can potentially earn 15%–25% returns on private equity real estate investments.
Get creative in how you approach your tax savings. And when in doubt, talk to an expert who can help you plan your tax strategy.
About the Author:
Brian Davis is a real estate investor, personal finance writer, and co-founder of SparkRental with over two decades in the real estate and finance industries. He owns fractional shares in over 2,000 units and regularly contributes as a real estate and personal finance expert for Inman, BiggerPockets, R.E.tipster, and more.
Disclaimer:
The views and opinions expressed in this blog post are provided for informational purposes only and should not be construed as an offer to buy or sell any securities or to make or consider any investment or course of action.