Like every investment opportunity, real estate has the potential to make investors a lot of money—but it can come with unexpected tax liabilities. Investors and property owners can help reduce their tax burden by applying strategies designed specifically around their investments and assets. From managing ownership to selling properties in installments, here are the five best ways to reduce taxes on real estate investments.
Managing Capital Gains and Losses
Selling your properties attracts either short-term or long-term capital gain tax rates. A short-term capital gains tax is applied to any property owned for less than one year; long-term capital gains taxes are applied to any property owned for more than one year. The short-term rate is the same as the taxpayer’s income tax rate, but long-term differs: the tax rate starts at 0% for a married filing jointly filer if taxable income is less than $80,800, then most net capital gains reach 15%, and finally 20% if taxable income exceeds the 15% rate thresholds.
Holding properties for more than one year is a more cost-effective way to maintain real estate properties while reducing your tax burden. There are some exceptions to the short- and long-term rules, including properties that were gifts or acquired from a decedent. Professional financial advisors or investment planners can help navigate the exceptions and find the optimal time to sell real estate with reduced taxes.
As with all investment strategies, real estate is susceptible to gains and losses. However, some tax rules allow taxpayers to lessen the severity of a loss: for example, tax-loss harvesting involves selling investments with unrealized loss to obtain credit for realized gains. Real estate sold is replaced with an alternative real estate investment to maintain a taxpayer’s portfolio asset allocation.
The loss of value in the initial property offsets the increase in the price of the subsequent property, thus deferring the capital gains tax liability. Should a taxpayer sell one investment with a realized gain of $240,000, taxed at a long-term capital gains tax rate of 20%, they may owe $48,000 tax liability; however, selling an additional investment with an unrealized loss of $100,000 can offset the initial mutual fund’s tax liability, resulting in a $28,000 tax liability.
Another way to avoid the capital gains tax is by exchanging business or investment properties. According to 26 U.S. Code § 1031 — Exchange of real property held for productive use or investment, “No gain or loss shall be recognized on the exchange of real property… if such real property is exchanged solely for real property of like kind.” While sold properties would usually be subject to capital gains tax on the profit earned, a taxpayer or investor can be exempt if the property proceeds are reinvested in another property.
Remember that the 1031 exchange requires properties to be of like-kind, so selling real estate must be reinvested in another real estate except for a taxpayer’s or investor’s personal residence.
Investors renting real estate properties can capitalize on deducting two forms of expenses: ordinary and necessary. Ordinary expenses are defined as common or generally accepted in the business, whereas necessary expenses include insurance, maintenance and repairs, and taxes. Property owners and investors can deduct the cost of materials, necessary work, and other things that maintain a property’s condition.
However, the cost of improvements are not deductible. Something is considered an “improvement” if it results in a new or different function of the property. While maintenance to maintain the quality of a property is deductible, adapting or changing the essential function of said property is not. Some improvements can be considered deductible, however, should the property owner file a Form 4562 to declare depreciation of the property.
Finally, consider installment sales when selling your real estate property. This requires the buyer to make regular payments over time, i.e. installments, plus interest (if installment payments are to be made in subsequent tax years). This method is useful for taxpayers looking to defer capital gains to future years. This can help the seller keep their income in a certain tax bracket by spreading out the payments received over time. By paying less taxes recurrently, as opposed to the total amount of tax owed upon sale, investors can reduce taxes on real estate investments.
Proactive planning is vital in reducing taxes and making your investments as profitable as possible. Tax planning strategies, like managing your tax bracket through installment sales, capitalizes on deductions and maintaining your income bracket. This minimizes the tax burden and saves money long-term. If you’re invested in real estate, contact us. Our experts will determine the best strategies for your portfolio and investment planning.