How to Avoid Capital Gains Tax on Real Estate

After reaching its peak in the summer of 2022, US real estate pricing is finally declining. Strategists believe home prices in places like California, Texas, and Arizona can lose 25% of their summer 2022 value, while experts believe it would be a moderate downturn.

Nonetheless, some of you may still want to sell your properties or get rid of a bad investment. There is a high chance that you could still make a good profit.

Like it or not, the IRS takes note of such transactions and asks you to pay capital gains tax (CGT). Depending on your profit and other factors, your payable CGT could be thousands of dollars.

However, there are ways to reduce such amounts significantly, or pay nothing, legally. In this article, we are going to cover 5 such ways.

What Is the Capital Gains Tax (CGT) on Real Estate?

If you sell your assets and make a profit, you are liable to pay a capital gains tax on the profit. Stocks, real estate, or collectibles - CGT applies to any instance of assets sold on profit.

Your capital gain tax on real estate depends on several factors:

• Duration of ownership
• The property’s status as primary residence
• History of rental income generated from the property
• Inheritance
• Your marital status, and many more

To have a better grasp of capital gains taxes on real estate, you need to understand its subcategories.

Short-term capital gains tax: If you own any real estate (or any asset for that matter) for less than a year and make a profit by selling it, you are subject to short-term capital gains tax. In that case, the IRS just adds the profit to your income and slaps an income tax on the total sum.

Here is an example: Suppose your annual income is $85,000, and you purchased a house for $250,000. After several months, you decided to sell it at $300,000. In that case, you would pay 24% (same as your income tax rate) of that $50,000 profit in taxes.

Long-term capital gains tax: If you own an asset (a property) for more than a year, you fall under long-term capital gains tax regulations. In this situation, you pay 15% (for average-income US residents) of the profit.

In the example cited above, if you own the property for 3 years, you pay 15% of your $50,000 profit.

Image: Long-term capital gains bracket 2023

Note: If you own your property for at least 2 years and use it as your residence, you will be exempted from paying CGT against the $250,000 capital gain if you are single. Forarried partners who file a joint return, this deduction can go up to $500,000.

However, vacation homes or second homes don’t qualify for this tax deduction.

5 Ways to Avoid Paying Capital Gains Tax on Real Estate

No one likes to hand over their hard-earned money to the IRS. Here are a few legal ways to save on your capital gains tax.

Avoid capital gains tax on your primary residence

One of the easiest ways to save capital gains tax is to show that you are selling a primary residence.

On the sale of a home, the IRS allows tax exemption up to $2,500,000 for single individuals and up to $500,000 if married partners file jointly. In other words, you pay taxes on the remaining amount after you deduct the exclusion amount from the profit.

Here is an example: Suppose you are a single male who bought a house at $300,000. After 5 years of occupying it, you sell it at $700,000. If you qualify for full home sale exclusion, your taxable amount will be $(700000 - 300000 - 250000) = $150,000.

In case you are wondering, here are the criteria to qualify for full exclusion:

• You legally owned that property for at least 2 of the last 5 years and used it as your home for at least 2 years.
• You didn’t sell another home (on which you claimed exclusion) within 2 years.
• You don’t pay expatriate tax.
• You didn’t use your property as a rental or vacation home or any part of it (outside of the living area) for business.
• You didn’t acquire the property through a like-kind exchange within the past 5 years.

Even if you don’t check all the boxes (especially if you lived on the property for less than 2 years), you won’t be going home empty-handed; the IRS offers a partial exclusion if you sell your home under the following conditions:

• Work-related move
• Health-related move
• Change in employment status
• A divorce
• Any other unusual event

Long story short, you can save big on taxes if the property in question is your home. However, you want to sit with your accountant and figure out what deductions you qualify for.

Raise your cost basis

The cost basis is the total sum of what you pay for your property and innovation/modification costs. For example, if you paid $700,000 for a house and spent an extra $50,000 on fixing it, your cost basis would be $750,000.

Why is this important?
Because your taxable amount is calculated by deducting your cost basis from your selling price. In the example cited above, if you sold the house at $1,000,000, the capital gains tax would be levied on $1,000,000 - $750,000 = $250,000.

If you can increase your cost basis by adding up all the money you spent on the property, you can reduce your taxable amount. However, to do so, you need to show proof of all the spending.

The problem is that losing some old receipts and documents is common, especially if you have owned the property for years. Unfortunately, you can’t deduct those amounts from the tax payable if you lose them.

One solution is maintaining an Excel sheet. But let’s be real, how many of us can keep up with maintaining all the records consistently unless house hacking is our main job?

A more practical solution is using bookkeeping applications like Fincent.

Once you link your real estate bank account (we strongly recommend that, remember?) with Fincent, it will automatically update and keep track of all your transactions, the details of which you can find in seconds using different parameters.

Here is what it looks like.

Also, you can easily save and organize your receipts and other necessary documents. During tax filing, you can search for them under the “Files” tab.

Do a 1031 exchange (like-kind exchange)

When you sell an investment or rental property, you are subject to capital gains tax. However, if you exchange the property for a similar investment property, you are not required to recognize any gain or loss under Internal Revenue Code (IRC) Section 1031.

In other words, if you swap investment properties, you avoid paying capital gains taxes on the transaction. But in the long run, you will still need to pay taxes when you sell your newly swapped property, unless you continue to swap properties in the future.

Nonetheless, it’s a great way to delay taxes while generating cash flow from your properties.

Such exchanges (known as like-kind exchanges) must meet the following criteria:

• The property must be an investment asset. You can’t use it as a primary residence, secondary residence, or even an occasional vacation home. As a rule of thumb, if you currently live there (and it doesn’t generate cash flow), your property doesn’t qualify for a 1031 exchange.
• Your property must generate consistent cash flow, be it in the form of rent or profit from a business. Therefore, any property you hold for later sale doesn’t qualify.
• The property you are buying must be similar to the original one in terms of “character and class.” Now, the IRS is pretty liberal when it comes to defining similar properties. As long as it is within US territory and capable of generating cash flow, there is a fair chance the property is good in the IRS’s books.
• Unless you are directly exchanging two equally-priced properties, a qualified intermediary is needed to hold the proceeds received from the old property and use them to buy the new property.

You don’t need to buy a new property right when you sell one. You are free to put the proceeds from the sale in escrow and then purchase a similar investment property within 180 days of the sale.

Essentially, 1031 exchanges are great for upgrading rental properties tax-free. You can swap your existing rental property with a new one that has more cash flow potential. However, to prevent the misuse of 1031, the American Job Creation Act of 2004 requires property owners to retain the exchanged property for a minimum of 5 years to qualify for the 1031 exclusion.

Note: Your second home is not eligible for a 1031 exchange. However, it can be if you convert it into a rental property.

First, you need to own the place for at least 2 consecutive years and rent it out for at least 14 days in each of those years. Second, you must not use the property for personal use for more than 14 days a year.

If these conditions are met, you can exchange your previous second home (a rental property at the time of sale) for another rental property through a 1031 exchange.

Pass the property down to your heirs

CGT only applies if you gain profits from selling your real estate.

But what if you don’t sell it at all, use it as a rental property/home, and pass it down to your heirs?

You pay no capital gains tax.

But the best part is that your heir doesn’t need to pay any CGT tax either. Moreover, unless we are talking about the 6 states that levy inheritance tax (Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania), he/she is not liable to pay inheritance tax. Further, no federal estate tax is levied if the inherited property is valued at less than $12.92 M in 2023. The only time they pay CGT is when they sell the property.

Here’s some more good news: Once the heir receives the property, the cost basis resets to the value of the property on the day of the inheritance. Therefore, if your heir immediately sells the property, he/she pays zero CGT. If he/she sells it at a later date, he/she pays CGT based on the new cost basis. Let’s look at an example:

You bought a house for $100,000 in 2012. On adding up all the repair costs, your cost basis comes up to $120,000 in 2023. If you sell it for $400,000, you make $280,000. If we don’t count the home sale exclusion, you pay CGT on $280,000.

But the moment you pass down the same property to your heir, the cost basis gets reset to $400,000 (the value of the property on the day of the inheritance). If he/she sells it immediately, the payable CGT on {$400,000 (selling price) - $400,000 (cost basis)} = $0.

And in case the price touches the $500,000 mark in the future, they would pay CGT on the profit, which is $100,000.

Tax loss harvesting

Tax loss harvesting is a great way to reduce the amount of CGT you owe to the IRS. In case you are not familiar with the term, when you purposefully take a capital loss to offset taxes owed on an investment sold at a profit, it’s called tax loss harvesting.

Here is how one can cut down on CGT using tax loss harvesting:

Let’s take the example of a single taxpayer A. A’s yearly income is $600,000, and he has three properties:

• Property X: Cost basis = $150,000; current value = $600,000; years owned = 7
• Property Y: Cost basis = $200,000; current value = $100,000; years owned = 0.5 (6 months)
• Property Z: Cost basis = $100,000; current value = $120,000; years owned = 0.3 (4 months)

If he sells 2 of his profitable properties, the CGT on property X would be (($600000 - $150000) X 15%) = $67,500.

For property Z, he has to pay (($120000-$100000) X 37%) = $7400 as CGT.

His total owed capital tax would be (we are not counting any exclusions here): ($67500+$7400) = $74,900.

But if he decides to harvest losses, he has to sell property Y at a loss. In that case, his total payable CGT will be:

[($450,000 X 15%) + {($20,000 - $100,000) X 37%)}] = ($67,500 - $29,600) = $37,900.

The IRS has set $3,000 as the limit on the maximum amount of capital losses you can use to offset any gains. When your capital losses exceed $3,000, the excess gets carried over to the next year.

Also, you can’t buy a substantially identical asset within 30 days before or after the sale, which leads to a capital loss. In the event of any violation, your tax deduction on the basis of capital loss will be denied.

Overall, tax loss harvesting can lower your taxes. However, you should always look at the big picture first before letting any asset go. Is getting the tax cut worth losing the asset? If the answer is a resounding yes, then go ahead.

Conclusion

Every time you make a profit by selling a piece of real estate, you owe capital gain taxes to the IRS. To be honest, both short-term CGT and long-term CGT can bite off a big chunk of any profit you make.

In this article, we have discussed some ways to avoid or reduce CGT. However, you should always consult your accountant before making a decision.

Also, we have already demonstrated how Fincent can keep track of your transactions and proofs of transactions (invoices, receipts, etc.). As a taxpayer, you understand how helpful such features can be, right?
Fincent can do a lot more than that. Please book a demo here to learn more.