We have a lot of clients that own real estate investments as another way to provide investment income and grow their net worth. I can appreciate the tax advantages and diversification of owning investment property; in fact, my wife and I have acquired a few income properties over the past ten years.
With real estate values nearing all-time highs again, many of our clients have unrealized capital gains in their real estate portfolios. Unrealized capital gains are not taxed; but if you want to sell your appreciated property, you have two choices:
a) Pay capital gains tax (currently up to 20%, plus a 25% tax on any accumulated depreciation that you must recapture).
b) Perform a 1031 Exchange, thereby deferring the tax, and transferring your cost basis to another investment property of equal or higher value.
What if I told you I have a strategy that can stretch your capital gains tax over multiple years, with the goal of remaining in a low tax bracket each year? What if I had a plan that would completely eliminate capital gains taxes on your investment property gains all together? Yes, we can help you avoid capital gains tax on millions of dollars in gains, potentially saving you hundreds of thousands of dollars.
First, the easiest way to stretch out your capital gains for tax purposes is to sell your investment property on contract to a buyer. A portion of each payment received from the contract is considered your basis, so you only pay tax on a portion of payments received each year. If you want to stretch it out over 10 years, draft a 10-year sale contract with a large (i.e. amount of tax) prepayment penalty.
Another way to stretch out the capital gains tax would be to perform a 1031 exchange and use the proceeds to purchase multiple like properties. So you could turn your 12-plex into five condos or single-family homes tax-free, using the 1031 exchange rules. Then, you could sell one or two units per year to stretch out your taxes and try to remain in a lower tax-bracket, to be taxed at only 15% – or even 0% (if you’re in the 15% tax bracket or lower)!
Now for the best part: The way to completely avoid capital gains tax takes the 1031 exchange into multiple properties one step further. Let’s assume you bought five condos as in the last example. 1031 exchange rules state that you can convert an investment property into a personal residence after three years of ownership. So let’s say three years from now, you move into one of the condos. You only have to live there two years to be able to sell it tax-free. So within five years, you’re realizing tax-free gains from your original investment property. Then every two years, you simply move to the next property, and put one up for sale. Within a decade, you will have realized huge gains without paying one cent of capital gains tax (from selling three of the five properties in the first nine years – at years 5, 7, and 9).
This strategy may seem like a bit of a logistical nightmare, but for savings of a few hundred thousand dollars, it may just be worth it!
(PS – For our advisory clients, we have an additional bonus in regard to this strategy, making it even easier and more profitable – just call our office and ask to speak with Adam about the specifics.)