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Strategies to Minimize Capital Gains Tax on Your Property
Let's face it, nobody enjoys paying taxes. Losing a significant portion of your income to various taxes, such as FICA taxes, federal, state, and local income taxes, can hinder your path to financial independence, particularly at a young age. While methods like depreciation and recapture can help defer and reduce taxes, the real goal is to find ways to either avoid or minimize capital gains tax.
Here are ten legally sound approaches to cutting down on capital gains taxes as part of your tax management toolkit:
1. Long-Term Ownership
It's a fundamental rule: if you hold a property for less than a year and sell it for a profit, you'll face a higher income tax rate. The key takeaway here is to resist the urge to sell immediately. Instead, consider keeping the property as a rental for at least a year. During this time, your tenants can contribute to paying off the mortgage while you hope for the property's value to appreciate. Alternatively, if you're concerned about potential damage to a newly renovated property, purchase a rental property with existing tenants, let them stay for a year or until they move out, and then proceed with renovations and sale.
2. Reside in the Property
By residing in your home for a minimum of two out of the last five years, you can enjoy an exemption from capital gains tax upon selling. The exemption amounts to $250,000 for single filers and $500,000 for married couples. You can leverage this by engaging in a live-in renovation, making property improvements over two years, increasing the selling price, and pocketing the profit tax-free. Alternatively, you can convert the home into a rental for a few years to further capitalize on appreciation before selling. Or, you can take the reverse approach and live in your rental property for two years before selling. As long as you've lived in it for two of the last five years, you can avoid capital gains tax.
3. Utilize a 1031 Exchange
The IRS offers an option known as a "like-kind exchange" under Section 1031 of the tax code. In essence, this allows you to use the proceeds from selling one property to acquire another similar property while deferring capital gains taxes from the sale. However, it's crucial to understand the nuances. "Like-kind" typically means properties used similarly, such as selling a rental property and using the proceeds to buy another rental property. There are time constraints as well—you must identify the replacement property within 45 days of selling the original property and complete the purchase within 180 days. Keep in mind that a 1031 exchange merely defers taxes; they become due when you eventually sell the new property at a profit, unless you opt for another 1031 exchange.
4. Invest through Self-Directed IRAs
Consider purchasing and selling properties within a self-directed IRA or Roth IRA, allowing you to reinvest the proceeds continuously. Traditional IRAs will incur taxes on gains upon withdrawal in retirement, but Roth IRAs provide tax-free withdrawals. Setting up a self-directed IRA can involve some effort and expenses, in addition to the tasks associated with property management and sales.
5. Document Capital Improvements
Keep meticulous records of capital improvements, which are upgrades that extend a property's lifespan. These improvements increase your property's cost basis, essentially the amount you paid for the property according to the IRS. For example, if you purchased a property for $100,000 and sold it for $150,000, you would typically owe capital gains taxes on a $50,000 gain. However, if you invested $15,000 in a new roof during your ownership, your cost basis would increase from $100,000 to $115,000. Consequently, you'd only owe taxes on a $35,000 gain. Accurate record-keeping is crucial for this strategy to be effective.
6. Timing Sales with Income Fluctuations
Selling a property during a low-income year can be beneficial because, with reduced income, you might owe no capital gains tax. For instance, if you're single and your adjusted gross income falls below $44,625, or if you're married and your adjusted gross income is under $89,250, you can potentially avoid capital gains tax. If you're experiencing financial challenges in a particular year, selling property during that period may help save on taxes.
7. Lower Your Taxable Income
While reducing your taxable income solely for tax reasons is not advisable, there are legitimate ways to achieve this goal. Contribute to tax-deferred accounts, such as an IRA or a 401(k), as part of your annual retirement planning. Additionally, consider contributing to a health savings account (HSA) if you're relatively healthy, as it can also lower your adjusted gross income. Tax deductions can further reduce your taxable income, although itemizing has become less common with the standard deduction at $12,200 for individuals and $24,400 for married couples. Keep in mind that if your adjusted gross income falls below $44,625 for singles or $89,250 for married individuals, you won't owe capital gains taxes.
8. Capital Loss Harvesting
Offsetting income from capital gains can be achieved by "harvesting" losses. This strategy involves selling assets, such as stocks, that have declined in value. If you've been holding onto underperforming assets, consider selling them to realize losses. These losses can offset gains from other investments, reducing your overall capital gains tax liability. After selling the underperforming assets, you can reinvest the proceeds in more promising investments, whether it's stocks, real estate, or a business venture.
9. Gift Properties to Family Members
Estate planning becomes a priority for older property owners looking to pass on assets to heirs with minimal tax implications. One option is to gift properties directly to your children while you're alive. If they retain the property for rental income or sell it while in a lower tax bracket, they may owe little to no capital gains taxes. However, when you gift a property to your children while you're still alive, the cost basis is transferred to them. This means that if you purchased the property for $100,000 and it's now worth $150,000, and they sell it for a $50,000 profit, they will owe capital gains taxes on the $50,000 gain because they inherit your cost basis. Alternatively, if the property is passed to them as part of your estate when you pass away, their cost basis resets to the market value at that time, which is often a more advantageous scenario. If your children intend to live in the property for at least two years, they may qualify for the personal residence exemption mentioned earlier. It's worth noting that you can gift cash, stocks, or other assets in addition to physical property, with a tax-free gift limit of $17,000 per person in 2023.