If you're one of the millions of Americans who recently opted to sell some property for considerably more than its original purchase price, you came out on top.
Sort of...
Now it's time to split the spoils with Uncle Sam, namely the IRS. And depending on your applicable tax bracket, they plan to collect up to a whopping 15%...ouch!
You worked hard, saved money, took diligent care of one of your most precious and profitable assets. Shouldn't you get to keep as much of that money as possible? Understanding the ins and outs of the rules is a great start to taking the sting out of capital gains tax on real estate, especially when it comes to rental property strategy.
Don't want to look like a deer in the headlights when meeting your tax professional? Let's dive into the ins and outs of capital gains tax on real estate, deferral strategy, the use of deferred sales trusts, and what to do when a property losses value.
Personal Property vs. Investment Property
Owner-occupied residences typically act as kind of a safe haven as far as tax liability is concerned. Those who are single can see savings on capital gains taxes of up to $250,000. If married and filing jointly, that amount can join up to half a million dollars.
Unfortunately, this isn't the case for investment property as the situation is a bit more complex and a lot less straight forward. This is where understanding the current rules behind capital gains tax on real estate can mean the difference between paying more or paying less.
Here's some good news for a change; the profit realized from your investment property isn't necessarily doomed to disappear when you file. By switching the status of the property from investment to personal or having lived in the property two out of the most recent five years, you can claim exemptions thereby reducing liabilities.
The Value of the 1031 Exchange
The United States was founded by landowners, so it should come as no surprise that there are landlord-friendly laws woven into the tax code. Congress has even gone so far as to give real estate investment professionals a break not available to holders of other financial assets, including stocks, bonds, and mutual funds.
Under the rules of the 1031 exchange, investors can defer the pain of capital gains tax by purchasing a property that is 'very similar' in nature to the one that was just sold. It isn't necessary for the two to be identical, but "like in kind." Essentially, both must serve similar functions such as rental for rental; and both must be within the jurisdiction of the United States.
A Losing Proposition
If any of your investments aren't panning out the way you thought, it's not the end of the road. There is, however, light at the end of the tunnel. Did you know that you can offset those losses just like the super savvy investor next door? How does he/she seem to come out of a bad property investment with their shirts still on their backs? Through a process known as tax loss harvesting, investors can turn losses into gains. The premise goes as follows: sell the losers and deduct the losses against your capital gains until you recoup. This technique works wonders when losing bets start to pile up.
Trust! When All Else Fails
A DST, or Deferred Sales Trust, is the wealthy investor's secret weapon. Let's say you've been through the gamut with your real estate portfolio and the exit is starting to look even better than it used to. You're eager to sell and have found an eager buyer. You can sell the property, pocket the profit all at once, and take the risk of having to fund a potentially high tax liability. Or you can set up a trust prior to the sale. The DST will act as an annuity, providing a steady source of income while deferring your liabilities, giving you more control within the bounds of your fee schedule.
It's time to blow the dust off the old Rolodex. Consulting with a tax attorney, tax accountant or financial planner to discuss the various ways to reduce the tax liability associated with the sale of a property is highly recommended.
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