Capital gains tax can take a big bite out of investment profits when you sell an asset like real estate or stocks. The capital gains rate is typically 15% for long-term holdings on federal taxes, and some states levy additional capital gains taxes. So if you have a substantial capital gain, the tax bill can really add up.
The most common way real estate investors avoid capital gains tax is by using a 1031 exchange to defer taxes. Section 1031 of the IRS tax code allows you to sell an investment property and use all of the proceeds from the sale to acquire a replacement property of equal or greater value. As long as you follow the rules, you can defer paying taxes on the capital gain indefinitely.
However, 1031 exchanges come with limitations and downsides:
– You need to identify and close on a replacement property within strict time limits.
– The properties must be like-kind to qualify.
– Any cash proceeds not reinvested are taxable.
– You have to take on a new property and the risks/work that entails.
For these reasons, some investors want to know if there are alternatives for avoiding capital gains tax when selling real estate without doing a 1031 exchange. The short answer is yes, there are a few options:
Tax-Deferred Installment Sale
One way to potentially defer taxes on real estate capital gains is to carry back all or part of the sale price using a mortgage or promissory note.
Here’s how it works:
– Seller finances the sale and carries back the note.
– Buyer makes payments over time, including interest.
– Seller declares gain annually based on principal payments received.
– Any remaining gain is taxed when note is paid off.
By spreading the capital gain over several years, the seller smooths out their tax liability. The interest also provides an offset to ordinary income.
There are some caveats with this approach:
– Requires finding a buyer who needs seller financing.
– Note payments and interest are ordinary income.
– Doesn’t completely eliminate capital gains tax.
– Adds risk that buyer defaults on the note.
Overall, an installment sale can help defer and reduce capital gains tax, but it doesn’t eliminate the liability like a 1031 exchange can.
Partial 1031 Exchange
Another capital gains deferral strategy is to do a partial 1031 exchange. Here’s how it works:
– Sell the investment property for a gain.
– Reinvest only part of the equity into a replacement property.
– Pay capital gains tax only on the cash proceeds not reinvested.
For example, say you sell a property for a $200,000 gain. You use $150,000 to acquire a replacement property and keep $50,000 in cash. You would only pay capital gains tax on the $50,000 cashed out.
A partial 1031 exchange gives you flexibility to take some cash off the table and still defer taxes on a portion of the capital gain. However, you still have to identify and close on a replacement property within the 45/180 day limits.
Charitable Remainder Trust
Donating real estate to a charitable remainder trust (CRT) is another creative strategy to avoid capital gains tax. Here is the basic structure:
– Transfer property into an irrevocable CRT.
– Claim a tax deduction for the charitable donation.
– CRT sells the property tax-free and reinvests the proceeds.
– You receive income from CRT for a term, remainder goes to charity.
This plan allows you to cash out of an appreciated property, while claiming a deduction to offset the capital gain. It transforms a lump sum gain into an income stream from the CRT.
There are costs, complexities, and risks with this method:
– Requires an experienced attorney to set up CRT.
– Deduction limits based on age and payout term.
– Loss of control over the sale proceeds.
– Payback obligation if you die before end of term.
For philanthropically-inclined investors, a CRT can eliminate capital gains tax while benefiting charity. But it requires careful planning and legal help.
Opportunity Zone Fund Investment
Investing capital gains into an Opportunity Zone fund is a newer tax strategy authorized by the 2017 tax law. Gains deferred this way can grow tax-free until 2026.
Here is how the Opportunity Zone tax break works:
– Sell investment property at a gain.
– Reinvest the gain amount into an Opportunity Zone fund within 180 days.
– Defer paying tax on the original gain until 12/31/2026.
– Avoid tax on any appreciation of the fund investment if held for 10+ years.
Unlike a 1031 exchange, you don’t have to buy another property. The Opportunity Zone fund invests your capital in businesses or real estate located in designated census tracts.
Pros of this approach include:
– Deferral of original capital gain until 2026
– Potential to eliminate tax on appreciation
– No need to buy replacement property
Potential drawbacks are:
– Need to vet Opportunity Zone deals carefully
– Tax basis resets to FMV in 2026, so tax is not eliminated
– Holding fund investment for 10 years ties up capital
For investors with long time horizons, Opportunity Zones offer another way to potentially minimize capital gains tax on property sales. But the deals can be complex and risky.
Cost Segregation Study
Accelerating depreciation through a cost segregation study won’t avoid capital gains tax directly. But it can generate larger depreciation deductions to net against capital gains.
Here’s how it works:
– Engineer inspects property to identify components with shorter depreciable lives.
– Reclassifies improvements from 27.5 years to 5, 7, or 15 years.
– Results in increased annual depreciation deductions.
– Reduces net capital gain on future sale.
For example, reclassifying 20% of improvements from 27.5 to 5 years could increase annual depreciation deductions by over $10,000.
The increased paper losses from a cost segregation study decrease your net capital gain when you sell. This directly reduces capital gains tax liability.
Potential advantages of this strategy:
– No need to reinvest proceeds or acquire replacement property
– Maximizes depreciation deductions to offset capital gains
– Relatively low upfront cost
The limitations are:
– Doesn’t eliminate capital gains tax completely
– You must have held property over one year to depreciate
– Depreciation recapture still applies on sale
Overall, cost segregation is a relatively easy way to potentially shave 15-20% off a future capital gains tax bill.
Death Step-Up in Basis
The death tax basis step-up is not really a tax strategy, since the capital gains tax is avoided by dying. But it’s worth mentioning in this context.
When someone inherits an appreciated asset like real estate, the cost basis is stepped up to current FMV as of the date of death.
This new basis eliminates all prior capital gains. So the heir can sell immediately and pay no capital gains tax, because there is no gain relative to basis.
The step-up rule can provide huge capital gains tax savings in estate planning scenarios. However, it requires holding assets until death, rather than selling during life.
Conclusion
While a 1031 exchange remains the gold standard for avoiding capital gains tax on investment property sales, there are alternatives investors should know about. Each strategy has pros and cons to weigh.
Tax-deferred installment sales, partial 1031 exchanges, charitable trusts, Opportunity Zone investing, and cost segregation can all potentially defer or reduce capital gains tax liability. For some investors, these options may provide better flexibility than a full-scale 1031 exchange.
No single solution is right for everyone. But understanding all the capital gains reduction techniques available allows you to choose the optimal tax strategy for your situation. With smart tax planning, you can minimize the capital gains bite and keep more of your real estate profits.