Life changes quickly, and your rental property is not immune to change. Eventually, you’ll sell that property or leave it to your heirs. When that time comes, you will face a number of considerations, including the tax implications of the transaction. There are ways to avoid paying capital gains on your rental property, but your options have a lot to do with how you intend to use the proceeds from the sale.
Use a 1031 Exchange to Defer Capital Gains Tax on Rental Property
A 1031 exchange allows you to reinvest the proceeds from the sale of an investment property in another real property of equal or greater value and defer capital gains taxes. Since it is an exchange of properties rather than a sale, one of the key requirements is that you do not receive or come into constructive receipt of those proceeds. With this in mind, a qualified intermediary must be used to facilitate the transaction. There are other requirements as well, including strict time limits.
As long as you follow the guidelines for the exchange, you can continue to defer capital gains taxes indefinitely. If you do so for the rest of your life, your property will be “stepped up,” and your heirs will only pay estate taxes on the property. The current estate tax deduction is $11,180,000.
Use Capital Gain to Offset a Loss
If you prefer to sell your rental property rather than exchange it, another way to minimize or in some cases, eliminate capital gains tax is to offset the gain with a loss on another investment. Sometimes a loss can be used to your advantage—and in a diversified portfolio, it may happen from time to time. While a 1031 exchange only allows you to exchange real estate for real estate, there is no like-kind requirement here. If you sell your rental property for a gain, it can be offset by money you lose on the stock market, for example. Not only that, if you experience losses that are greater than the gains they offset, you can apply up to $3,000 of the loss against ordinary income for married taxpayers filing jointly, or $1,500 for single filers, and remaining loss can be carried over to future years.
Be that as it may, the principle of balancing gains and losses can be applied systematically for profit. This practice is known as tax-loss harvesting. Like capital gains, capital losses are calculated as short-term or long-term, and the short-term rate is higher here, just as with capital gains. Tax-loss harvesting works by balancing short-term losses (losses on assets held for less than a year) with gains that are eventually taxed at the lower long-term capital gains tax rate. Tax-loss harvesting is an extremely complex process, even by the standards of tax accounting. It is especially complicated when real estate is involved due to the numerous fees that have to be factored into the calculations. It should only be attempted with the guidance of specialists.
Move In and Save Elsewhere
If you would like to convert your rental property into your primary residence, you can get a big break on the capital gains tax from the sale of your current primary residence. If you have owned your current primary residence for at least five years and have lived in it for at least two years, IRC 121 allows you to exempt capital gains of up to $500,000 for joint filers or $250,000 for single filers when you sell it.
Once you meet the qualifications for the IRC 121 exemption, which is relatively easy to do, you can move from the rental property that was converted into your primary residence and take advantage of the exemption again, if you wish to. Exclusions can be made to the ownership and residency requirements under some circumstances (change of marital status, change of job, health considerations, etc.), but be sure that you will be able to document your life changes thoroughly if the IRS asks you to.
Tax planning is complex, which is why seeking sound advice is important when making major financial decisions. But when done right, it can produce highly satisfying results.
At CWS Capital Partners, we are a fully integrated multifamily real estate investment management firm that offers everything from due diligence and risk management to transaction support and property management. We specialize in assisting our clients with 1031 exchanges, acquisitions, repositioning, and development. We also own and manage luxury multifamily investment communities in major markets around the country, and employ a team of experts who can help you hone your investment strategy.
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