How To Avoid Capital Gains Taxes

If you have been fortunate enough to own real estate in the past 10 years, you are likely seeing some amzing increases in the value of your property. In fact, the market has been steadily climbing year over year since 2008, with median home prices increasing over 150% nationwide (and 300% in some markets). This equity you have in your properties can open many doors for other investments, paying off debt, or even early retirement. That said, as soon as you sell your property the IRS will be waiting to collect capital gains taxes. You could easily sell your property, pay your capital gains taxes with the proceeds, and move on. However, if you are looking to maximize your profits and asking yourself “How do I avoid capital gains taxes”, there are smarter ways to legally defer your taxes or even have someone else pay them for you. Below are 2 of the best options, one very well-known and the other used mostly by experienced investors who understand tax law and the power of interest. These two tools are the 1031 Exchange and the Installment Sale:

Option 1: The 1031 Exchange

This is the most common tactic used to avoid paying capital gains taxes, and it works well in some cases. By using all of the proceeds from the sale of your investment property to purchase a “like-kind” property, you avoid paying the capital gains taxes (for now) and the gains realized are moved to the new investment property. You are also allowed to “reset” your depreciation, which has it’s own tax advantages. That said, you are not getting rid of capital gains taxes, you are simply deferring them to a new asset. This means that when you decide to sell the new asset, you must pay capital gains.

A 1031 Exchange isn’t without its drawbacks. This entire process is held to a strict timeline, with just 45 days to identify your “like-kind” asset and other deadlines tied to the close. As we mentioned above, you aren’t getting rid of your tax obligation. You are simply deferring it to the next property, making it a problem for “future you” to deal with. You also don’t have access to any of this equity because you are required to roll it all into a new property (or you will get taxed).

When using a 1031 Exchange, you are also still exposing yourself to the ups and downs of the real estate market. If your new asset decreases in value, you incur that loss directly. And, of course this also means you are still responsible for managing and maintaining a piece of real estate. This last point can be a real deal-breaker for some investors, especially those looking to liquidate their portfolios and stop the headaches of being a landlord.

Option 2: The Installment Sale

Next up is the lesser-known, but arguably even more powerful Installment Sale. Simply put, it allows you to earn interest on your equity and use that to pay off your capital gains. You are left with more profit, and with no strings attached. Your capital gains obligation is eliminated entirely and you can use that money for anything you want.

The Installment Sale strategy that is getting more popular as of late because it offers many advantages that a 1031 Exchange does not. Per Section 453 of the US Tax Code, which pertains to installment sales and related tax provisions, it lets people sell a property, defer the capital gains tax and roll the money into investments other than just real estate.

So, what does this mean exactly? This means that you are only required to pay capital gains taxes on money that you have received. So, in structuring your sale on an Installment Contract that spans over multiple years, you are only responsible for the principal portion of funds received each year. And, once you’ve received this money, you can do anything with it you please. It isn’t tied to any assets or restrictions.

It gets better. Of course, you aren’t holding a multi-year contract for free, so you are earning interest every month on top of the principal payments. And, as most real estate investors are aware, a mortgage amortization is heavily front-loaded with interest. The end result is you are able to pay off your capital gains taxes each year with the interest you earn from carrying an installment contract, and you pocket the rest as income.

This is a lot of information, so let’s use an example. Let’s say you purchased an investment property 10 years ago and are selling it today for $1,000,000 with a capital gain of $500,000. Under a normal sale, you would pay the capital gains taxes on that $500,000 at the time of close (over $100,000 depending on your tax bracket and state). Ouch.

Using an Installment Sale in this example, you would draw up an installment contract that would require the buyer to pay you over a predetermined period. Because you sold in agreement to be paid over time, you wouldn’t have to pay taxes on the sale until you start receiving those installment payments from the buyer.

You can agree to take your payments over a 5-, 10-, 20-year period, or over your lifetime. You can even defer your principal payments and only receive interest each month, which incurs zero capital gains. Remember, the IRS code doesn’t require the payment of capital gains taxes until you start receiving the principal installments.

In this example, if you held an installment note for 10 years, you will have made enough interest to completely pay off your capital gains taxes and pocket an additional $250,000 in income.

Anyone who has dealt with capital gains taxes knows they can be pretty high: 15% for single filers with taxable income up to $418,400 ($470,700 for married filing jointly), and 20% if you earn more than that. Plus, you’ll likely have to pay the 3.8% net investment income tax embedded in the Affordable Care Act. Then there are state taxes to deal with, perhaps another 10%. So now you’re talking about approximately 34%, and if you have a depreciation recapture tax, that’s another 25% (another 5 to 10 percentage points higher than the typical capital gains tax rate). You could easily be paying — depending on what state you’re in — 30% to 40% in taxes when you sell. An Installment Sale could cut that tax bill in half.

Another major benefit of the Installment Sale is the lifestyle it provides for the seller. You may have grown used to monthly cash flow from your real estate assets, and an Installment Sale gives you exactly that while eliminating any responsibility you once had to the property or it’s occupants. In the example above, you the seller would be receiving over $4,500 a month from the buyer. You are essentially the bank, sitting back and collecting checks on an investment that is collateralized by a piece of real estate.

In conclusion, both the 1031 Exchange and the Installment Sale methods are great answers to the age-old question of how to avoid capital gains taxes. Each has their own pros and cons. If you want to stay in real estate, don’t mind being a landlord, and are OK with the risk of exposure to the market, a 1031 Exchange could be a good option for you. If you are looking to get rid of your capital gains taxes all-together, are tired of being a landlord, and enjoy passive income the Installment Sale could be the right fit for you. Either way, Puget Sound Home Buyers is here to help you through the process. We have done 100s of these transactions and may even buy your house from you directly if it meets our criteria. Call us at (253)289-7220 today or fill out this short form below: