Uncle Sam, aka the IRS, is always looking at the money that you make from your investments in real estate. There are different scenarios of how you will pay tax on your gains when you own real estate, I will give a few instances below along with how to avoid paying those taxes.
Short-term capital gains
If you own a home for less than a year, and sell it, you will be paying short-term capital gains tax. Short-terms capital gains tax is taxed at the same rate you pay as your income taxes, which varies depending on your income. In my case, if I were to sell a rental home that I just purchased, it would be taxed at 22%. YIKES! Therefore, if I were to sell my most recent rental property and let’s say it sells for $30,000 over what I owe on it, I would be paying Uncle Sam $6,600 and only making $23,400 in profit.
Long-term capital gains
If you own a home for a year or more, you will be paying long-term capital gains tax. Long-term capital gains tax depends on your taxable income, and what status you file under, but it will more than likely be lower than short-term capital gains. The tax rates remain at 0%, 15%, or 20%. In my case, I would be paying 15% in long-term capital gains tax, which on the same example as above it would equate to $4,500. That’s a little better, but still that is quite a bit of money given to Uncle Sam for us to do all the work for him.
1031 Exchange
Let me introduce you to a cool little legal term called the 1031 exchange. This is an awesome way to avoid paying taxes altogether! When you are thinking of selling your house, hopefully you have a plan for what you are going to do after you sell your house; buy another house? Another property? Or are you just looking to pull the equity out to have on hand cash? If you are looking to simply have the cash on hand, sorry- you’ll have to pay capital gains tax. If you are looking to simply switch your investment house to a closer location, or you have just reached the end of your investment goal for that property, you are in LUCK!
You can sell your property, and roll the equity in to a different property at 0% tax.
There are a few stipulations, but nothing that you can’t handle. You simply have to have an offer on an property within 90 days of selling your initial property. Before 2019 it was a ‘similar or more expensive property’ than you initially owned, but I believe now that it does not matter what kind of property it is. That is great news! My group has done a 1031 exchange, and we will definitely continue to take advantage of that tax law. It really is a great way to take advantage of ALL your earnings from investment properties for as long as you can.
Your best bet is to ask your accountant what option would be best for your specific case, but make sure to be your own advocate for the 1031 exchange. Some accountants have never done this before in real estate, so now you can be the expert, and teach them.
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