Avoid Capital Gains Tax on Your Primary Residence

1. Avoid Capital Gains Tax on Your Primary Residence

When you sell a property that you’ve lived in for at least two of the last five years, you qualify for the homeowner exemption (also known as the Section 121 exclusion) for real estate capital gains taxes.

Single homeowners pay no capital gains taxes on the first $250,000 in profits from the sale of their home. Married homeowners filing jointly pay no taxes on their first $500,000 in profits.

You don’t have to live in the property for the last two years, either. Any two of the last five years qualifies you for the homeowner exclusion.

Consider doing a live-in flip, where you live in the property for two years as you renovate it, then sell it for a profit. This is fun if you’re handy and enjoy fixing up old homes.

You can use the homeowner exemption repeatedly, moving as frequently as every two years and avoiding capital gains taxes. But you can’t use it twice within a two-year period. 

Check If You Qualify for Other Homeowner Exceptions

2. Check If You Qualify for Other Homeowner Exceptions

Raise Your Cost Basis by Documenting Expenses

3. Raise Your Cost Basis by Documenting Expenses

Do a 1031 Exchange

4. Do a 1031 Exchange

You’ll need a good exchange accommodator.

Gary Gorman 

does a great job, you can 

Sell in a Year When You’ve Taken Other Losses

5. Sell in a Year When You’ve Taken Other Losses

Sell Real Estate Syndications in a Year When You’ve Taken

Other Losses

6. Sell inLadder Real Estate Syndicationsa Year When You’ve Taken Other Losses

Harvest Losses

7. Harvest Losses

Sometimes, investors strategically sell for a loss, and use that loss to offset their capital gains. It’s called harvesting losses, and it makes sense when you have assets you don’t like or that underperform for you.

Say you bought a portfolio of five rental properties. You find yourself short on cash and want to raise a little capital by selling one, but don’t want to pay capital gains taxes on it. One of the properties turned out to be a lemon, and has caused you nothing but headaches and negative cash flow. To offset the gains of selling a property with some equity, you decide to harvest some losses by getting rid of the lemon at the same time. It’s just costing you money anyway, so now makes a great time to sell it.

You sell both properties, and the loss from the lemon washes out the gains from a “good” property. You ditch the underperformer that was costing you money each month, and you avoid property gains taxes on the property you sold for a profit.

A more common example involves stocks. Say you buy a stock that consistently underperforms, and you have no reason to believe it will leap up in value in the future. Rather than letting your investing capital languish in the no-man’s-land of bad returns, you cut your losses by selling it, and put the money toward investments that will generate higher returns.

Convert Your Home into a Rental Property

8. Convert Your Home into a Rental Property

If the homeowner exemption leaves you still owing capital gains taxes, you could always just keep the property as a long-term rental. As long as the property cash flows well, there’s no reason to ever sell it!

Let it generate passive income for you, month after month, year after year. As a buy-and-hold property, you can keep depreciating it for accounting purposes even as it appreciates in value.

Before converting your home into a rental property, run the numbers through a rental cash flow calculator. You may find your money could perform better for you by buying a property specifically as a rental, or even in the stock market, rather than sitting tied up in your ex-home. That goes doubly when you can avoid capital gains taxes on the first $250,000 or $500,000 in profits.

 

No one says you have to rent the property out to long-term tenants.

Run the numbers to calculate how it would perform as a vacation rental on Airbnb instead. You might just find it cash flows better.

Just watch out for local regulations designed to restrict short-term rentals — some cities effectively ban Airbnb rentals.

Carry Back Owner Financing 

9. Carry Back Owner Financing 

When you sell with owner financing and report it as an installment sale, it allows you to realize the gain over several years. Instead of paying taxes on the capital gains all in that first year, you pay a much smaller amount as you receive the income. 

This allows you to spread out the tax hit over may year.

Move to a State with Lower Taxes

10. Move to a State with Lower Taxes

Uncle Sam isn’t the only one after your tax dollars. Most state governments actually take a harder stance than the IRS on capital gains from real estate, charging income taxes at the normal tax rate. 

Nine states charge a lower long-term capital gains tax rate however, similar to the federal government: Arizona, Arkansas, Hawaii, Montana, New Mexico, North Dakota, South Carolina, Vermont, and Wisconsin. Another seven states charge no income taxes at all: Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming. Finally, New Hampshire and Tennessee don’t charge regular income taxes, but do tax investment income.

Consider moving to a state with a lower tax burden to keep more of your money where it belongs: in your own pocket.

Pull Out Your Equity by Borrowing, Not Selling

11.Pull Out Your Equity by Borrowing, Not Selling

You don’t have to sell your investment property in order to cash out its equity. Why not pull out the equity and keep the property to boot?

When you own a rental property free and clear, it does cash flow better. But you can still take out a rental property loan or a HELOC against your investment properties to access the equity, all while the property continues to appreciate in value and generate income for you each month.

Your tenants pay off your loan for you, and all the while you keep benefiting from cash flow, appreciation, and investment property tax advantages.

Pass the Property to Your Heirs as Part of Your Estate

12.Pass the Property to Your Heirs as Part of Your Estate

No one says you have to sell your property if you choose not to. Why not keep it until the day you die, and then pass your investment property on to your heirs? It can keep generating passive income for them as well.

And they probably won’t pay any inheritance taxes on your rental property either. Your heirs get a free pass on the first $11.7 million you leave them in tax year 2021, so unless you die with 30 properties, they probably won’t get hit with inheritance taxes.

Best of all, the cost basis resets upon your death. Again, cost basis is what you paid for the property plus any capital improvement costs, and it’s the “basis” on which any profits are taxed. When you die, it resets to the property value at the time of your death.

For instance, say you buy a property for $100,000, and over the next 30 years you put another $60,000 in capital improvements into it. Then you die and leave the property to your child.

At the time of your death, the property is worth $500,000. If your child were to sell the property, their cost basis for tax purposes would be $500,000 rather than the $160,000 in purchase price and improvement costs that you actually paid.

You avoid real estate capital gains tax entirely, your child avoids inheritance taxes, their cost basis resets so they wouldn’t owe capital gains taxes on all the equity you built, and they get an income-producing property. This works for everyone.

“Sell” the Property Using a Commercial Master Lease

13.“Sell” the Property Using a Commercial Master Lease

You can use a Commercial Master Lease to transfer all of the operational duties to a buyer who agrees to wait to close on the deal until after you pass away someday, which will hopefully be a long time from now! This allows you to avoid paying capital gains tax because, just like in the example above, your basis is increased to the property value at the time of your death.

To do this you’ll need to agree on a monthly lease amount that you get every month. Your buyer (who is technically called a Master Tenant) will pay this amount to you and take care of 100% of everything from renting the units to paying the property taxes. 

In exchange for this you’ll agree on a set purchase price that will be used as the property value when the buyer actually takes title in the future when you finally pass way. 

Buy or Transfer the Property to a Self-Directed Roth IRA

14.Buy or Transfer the Property to a Self-Directed Roth IRA

With a self-directed IRA, you get to invest in any assets you like, within a few constraints from the IRS. That makes self-directed IRAs a darling of real estate investors across the county.

And with a Roth IRA, of course, your assets grow tax-free so you don’t pay taxes on profits and returns.

Still, proceed with caution when it comes to self-directed IRAs. They come with setup and administration expenses, and add another layer of complications. Self-directed IRAs add particular challenges when you use real estate leverage to finance with a rental property loan.

Do your homework thoroughly, speak with your financial advisor, and consider leaving your IRA investments to stocks — real estate comes with plenty of its own cooked in tax advantages, after all.

Donate the Property to Charity

15.Donate the Property to Charity