Investing in real estate is profitable for thousands of investors, but it also hits many in the gut when tax time comes around. Capital gains mean increased income, higher tax liabilities, and more frustration on the part of real estate investors. Suddenly the profits you thought you made get swallowed up by Uncle Sam.
Does it have to be this way or are there ways to avoid capital gains when investing in real estate?
While avoiding taxes is never a good thing, there are ways to decrease your tax liabilities that the IRS allows and even encourages. We’ve uncovered the top methods for you to enjoy your real estate investment income below.
Offset Your Gains
The most popular way to avoid capital gains taxes is to offset your earnings. You can still earn the profits from your hard work in real estate investments, but offset them with a loss from another investment.
The technical term is tax-loss harvesting. You’ve likely heard it if you invest in the stock market, but it works in real estate too. You can combine the two – say a gain in real estate and a loss in the stock market. Your loss in the stock market will offset the gains made in the real estate market leaving more money in your pocket at tax time.
Take Advantage Of Like-Kind Exchanges
If you’re truly invested in real estate investing, plan your strategy accordingly. Before you sell a property, line up a purchase or at least a strategy to purchase another rental property. The IRS calls this a ‘like-kind exchange.’ In exchange for your profits on the sale, you immediately reinvest in another investment property, not realizing capital gains, but rather reinvesting your funds.
Just how ‘like’ they need to be varied. Before you use this method, talk with your tax advisor to make sure your exchange will be recognized under tax section 1031.
Use Your Retirement Account To Invest In Real Estate
This gets tricky, so definitely involve your financial advisor, but if you have a self-directed IRA with a large balance (enough to pay for the full cost of the house); you can use the funds to invest in real estate.
All proceeds earned (rent or the sale of the property) go directly into your IRA. You don’t see the cash flow yourself, but it increases your retirement fund and you avoid capital gains taxes. The only taxes you pay are those due when you withdraw the funds during retirement.
Convert It To A Primary Residence
It may not be ideal, but moving into your rental property for two years can save you on capital gains. The IRS allows exclusions of up to $250,000 for single-filers and $500,000 for married filing joint couples on real estate capital gains if they sell their primary home.
You may not be able to exclude 100% of the capital gains, but every bit helps. You must live there for two years before you can’t take the exclusion as long as you’ve owned the property for five years. That’s the IRS rule – own it for five years and live in it for at least two of the last five years.
Now, the IRS will prorate your exclusion based on the number of years the home was an investment property. Let’s say you owned the property for 6 years and lived in it for 2 of those years. You may exclude 33% of the capital gains for the time you lived in the home because it was an investment property for 66% of the time you owned it.
If you’re a real estate investor, start thinking now about how you’ll offset your capital gains if they’ll push you into a higher tax bracket. The hard work and time you put into the investment deserve the profits you earn, but taxes can greatly diminish them.
Look at your options to offset your taxes, whether that means offsetting the gains with stock market losses, investing in another real estate property right away, or converting the property to a primary residence, you have options, but none of these decisions should be made overnight. Create a strategy before you buy your investment home to determine the best way to manage your real estate investments and walk away with the largest profit.