Real estate investments come with a slew of tax advantages. While you own the property as a rental, you can take nearly two dozen landlord tax deductions.
Then, when it comes time to sell, you can reduce or avoid capital gains taxes on real estate through another dozen options.
Start thinking about your real estate exit strategies now, long before you’re actually ready to sell. By positioning yourself early, you can dodge the bullet of capital gains taxes on investment properties altogether.
Short-Term vs. Long-Term Capital Gains: An Introduction
Before diving into individual strategies to avoid real estate capital gains taxes, you first need a baseline understanding of short-term versus long-term capital gains.
If you own an asset — any asset — for less than a year and then sell it for a profit, the IRS classifies that profit as a short-term capital gain, taxed at your regular income tax rates. For example, say you flip a house and earn a $50,000 profit on top of your $85,000 salary. As a single person, you would pay taxes on that extra $50,000 in income at the 24% federal tax rate.
When you own an asset for more than a year and sell it for a profit, the IRS classifies that income as a long-term capital gain. Instead of taxing it at your regular income tax rate, they tax it at the lower long-term capital gains tax rate (15% for most Americans).
Here are the long-term capital gains tax brackets for 2020 and 2021:
2020: Married Filing Jointly
2021: Married Filing Jointly
$0 – $40,000
$0 – $80,000
$0 – $40,400
$0 – $80,800
$40,001 – $441,450
$80,001 – $496,600
$40,401 – $445,850
$80,801 – $501,600
The easiest way to lower your capital gains taxes is simply to own the asset, whether real estate or stocks, for at least a year.
Other Ways to Avoid Capital Gains Tax on Real Estate
No one wants to pay more taxes than they have to. But as a real estate investor, you have far more options than the average American to lower your taxes, at least on the profits from your investment properties.
Beyond owning the property for at least a year, try the following tax tactics to reduce or eliminate your real estate capital gains taxes entirely.
1. Live in the Property for 2 Years
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. It makes for a fun way to house hack, if you’re handy and enjoy fixing up old homes.
Alternatively, you could house hack a multifamily property, then either sell it after two years or keep it as a rental. Either way, you get to live for free and pay no real estate capital gains taxes! Toy around with our house hacking calculator to plug in any property’s cash flow numbers.
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.
2. Check If You Qualify for Other Homeowner Exceptions
Had to move in under two years? You may still qualify for a partial exemption from capital gains taxes on your primary residence.
The IRS offers several exceptions for homeowners who were forced to move, whether for a change of job, health issue, or other unforeseeable events. If you lived in the property for less than two years and were forced to move, speak with your accountant about any partial capital gains exemptions you might qualify for.
3. Raise Your Cost Basis by Documenting Expenses
Here’s a quick terminology lesson for non-accountants: your cost basis is what you paid for a property or other asset, including renovation costs.
Say you buy a property for $100,000, put $40,000 of repairs into it, then sell it for $200,000. You’d calculate your profit by subtracting your $140,000 cost basis from your $200,000 sales price, for a taxable profit of $60,000. (In the real world you’d have all kinds of other deductible expenses, such as the real estate agent’s commission, but they distract from the point at hand so we’re ignoring them.)
It’s easy enough to keep your receipts, invoices, and contracts when you’re flipping a house over the course of a few months. But what about when you own a rental property for 30 years? All those receipts, invoices, and contracts tend to get lost over the years, but they can help lower your capital gains tax bill when it comes time to sell.
The cost of every “capital improvement” you make to the property can add to your cost basis, reducing your taxable gains. Returning to the example above, you buy a rental property for $100,000, and over the next 30 years you pay $500 here and $1,500 there in capital improvements such as new windows, roof repairs, kitchen updates, landscaping, new driveways, and so forth. It adds up to $40,000 in total capital improvements, but it’s spread out over 30 years.
When you sell the property for $200,000, you can raise your cost basis by that $40,000 and pay capital gains on $60,000 rather than $100,000 — but only if you kept all those receipts and invoices. Save digital copies of all cost documents in a folder specifically for that property that you can pull up when it comes time to sell. It can save you tens of thousands of dollars in taxes!
4. Do a 1031 Exchange
The IRS lets you swap or exchange one investment property for another without paying capital gains on the one you sell. Known as a 1031 exchange, it allows you to keep buying ever-larger rental properties without paying any capital gains taxes along the way.
It works like this. You scrimp and save the minimum down payment for a rental property, buying a property for $100,000 and setting aside the cash flow for a few years. The property builds equity, appreciating in value to $120,000 even as you pay down the mortgage, and after a few years you’ve set aside more cash to boot. You sell the property, and instead of paying capital gains taxes on the profits, you put them toward a down payment on a $200,000 multifamily rental.
A few years later you buy a $350,000 multifamily property, and a few years after that a $600,000 property, each of which produces more real estate cash flow than the last. Eventually, you reach financial independence, with enough cash flow to live on — and you never had to pay a cent in real estate capital gains taxes.
5. Sell in a Year When You’ve Taken Other Losses
Capital losses cancel out capital gains. So if you get hit with losses one year, that year makes a great time to sell your property so your losses offset your gains.
Imagine the stock market dips 10% and you sell off some stocks, hoping to avoid further losses from market correction or bear market. You take $20,000 in losses from selling those stocks.
Meanwhile you own a rental property that you’ve been meaning to sell. You decide to sell it now, knowing you can offset your capital gains on it with the losses you took on your stocks. You sell the property for a profit of $30,000, and you pay capital gains taxes on $10,000 after subtracting the $20,000 in losses from stocks.
Perhaps you even luck out with the timing, putting that $30,000 back into the stock market at its low point and riding the recovery upward.
6. 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.
7. 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!
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.
8. Convert Your Home into a Short-Term Rental
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.
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9. 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.
10. 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.
11. Pass the Property to Your Heirs as Part of Your Estate
No one says you have to sell your property. Ever.
Why not keep it until the day you die, and pass the golden goose on to your heirs? It can keep generating passive income for them too.
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 gnarly 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 favorite child (we both know you have one).
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. Win-win-win-win.
12. 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.
13. Donate the Property to Charity
You could leave your property to your children. Or you could tell the spoiled brats to go earn their own fortune, and give your property to charity instead.
Not only do you not have to pay real estate capital gains taxes, but you also get a juicy tax deduction. For your entire equity in it, based on the current market value of your property.
As a nonprofit organization, the charity doesn’t pay any capital taxes on the property either. Again, both you and the recipient win, and the only party losing out is the IRS.
When you own an investment property for decades, as so many buy-and-hold investors do, you can rack up some serious equity. Equity that the IRS would love to tax you on, when you go to sell.
So? Outfox them by using one of the dozen strategies above to avoid capital gains tax on real estate. For the price of a little foresight, you can dodge the taxman’s grasping claws, and in the process leave greater wealth behind for your children or favorite charities.♦
What tactics do you use to avoid real estate capital gains tax? What questions or concerns do you have about capital gains taxes moving forward?
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About the Author
G. Brian Davis is a landlord, real estate investor, and co-founder of SparkRental. His mission: to help 5,000 people reach financial independence by replacing their 9-5 jobs with rental income. If you want to be one of them, join Brian, Deni, and guest Scott Hoefler for a free masterclass on how Scott ditched his day job in under five years.