What is a capital gain?
Wikipedia very simplistically defines it: A capital gain is the profit that results from a sale of a capital asset, such as a stock, bond or real estate, where the sale price exceeds the purchase price. The gain is the difference between a higher selling price and the lower purchase price. It also refers to the profit received from an asset that is regarded as “investment income” in the form of cash flow or passive income that arises in relation to property (real estate), financial assets (stocks/bonds) and intangible assets. A capital gain occurs only when the asset is sold. This is important to remember because it means that fluctuations in the value of the asset are not considered as taxable events.
How can you avoid paying capital gains tax on real estate?
There are actually several ways, which we will briefly describe here:
Primary Residence Exclusion
Individuals can exclude up to $250,000 ($500,000 for a married couple) of capital gains from the sale of their property utilizing the primary residence exclusion. To qualify for this exclusion, you must have used the property you sell as your primary residence for at least two of the five years prior to the sale.
If you’re intending to flip a property, claim the under-market investment purchase as your primary residence while you are making renovations. When you decide to flip it, ideally you’ll sell for a better sales price and avoid tax on your gains via the primary residence exclusion.
The 1031 Exchange
If you own investment property and are thinking about selling it and buying another property, you can avoid capital gains and depreciation recapture taxes by rolling the proceeds from the sale into a 1031 Exchange within 180 days time. The sale proceeds are transferred directly to a Qualified Intermediary who holds the funds until a replacement property is purchased, when you can reinvest in a property or properties of like kind and equal or greater value. The main benefit of a 1031 exchange (rather than simply selling one property and buying another) is the tax deferral.
The Long Term Benefit
If an asset is held for one year or less, it’s considered a short-term capital gain and it will be taxed at normal income tax rates. If an asset is held for more than one year, it’s considered a long-term capital gain which are taxed at the same rates as qualified dividend income. In 2019, LTCGs are taxed at a 0% rate if they fall below $39,375 of taxable income ($78,750 if you’re married filing jointly). They are taxed at a 15% rate if they fall above the 0% threshold but below $434,550 ($488,850 if married filing jointly).
If your career places you into a higher tax bracket, you can benefit from contributing to a Traditional IRA or a 401K. This both reduces your income while you are in the higher tax bracket and eliminates any capital gains as a result of trading in the account. Investing and strategically allocating appreciated asset classes into a tax-deferred account avoids the capital gains tax normally associated with trading (this does not include investing in the S&P 500, because is a capitalization-weighted index which misses the emphasis on value). When you withdraw from these types of accounts during retirement age, withdrawals from these accounts can be made in the lower tax brackets.
If you are not in a higher tax bracket or nearing retirement age, contributing to a Roth IRA can be another excellent tax strategy. While traditional accounts postpone paying taxes to a more favorable year, Roth accounts avoid them altogether. Because you pay tax on your deposits, a Roth account allows tax-free growth for the remainder of your life and also the lifetime of your heirs.
Health Savings Accounts
HSA’s are one of the few accounts where you can receive a tax deduction for contributing to them. Invest in an HSA account and you won’t pay any taxes as long as you use withdrawals for qualified health expenses.
Investment strategy can be confusing and overwhelming!
For more information or advice on utilizing any of these strategies, please call or email us. We are happy to offer advice or explain anything further. If we can’t help, we can refer you to the right professionals!