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MAIN TAKEAWAY. When buying real estate for investment, whether residential property or commercial buildings, the primary goal upon exiting is to profit from the sale. These earnings, known as capital gains, are subject to specific taxation. Therefore, one of the most critical factors to consider when exiting an investment is the impact of federal taxes on the sale.
What are Capital Gains?
NEXT STEP: Learn how capital gains taxes work, how to minimize capital gains and capital gains taxes, and explore how to create the best strategy to maximize your profit on exit.
Capital assets refer to anything you can buy, use, or sell for personal or investment reasons. These assets encompass tangible items like buildings, land, cars, and furniture. Intangible investments look like bonds, stocks, or intellectual property.
An entity selling a capital asset, after initially purchasing it, may realize capital gains or losses from the sale of that asset, depending on the property’s value relative to purchase. Two essential points are considered:
- Adjusted basis. Typically, the original purchase price plus all applicable improvements, sale expenses, finance costs, depreciation, and tax credits.
- Final sale price. The actual dollar value of the property at the time of sale, excluding selling expenses. Selling expenses are capitalized on the cost basis of the capital asset. The final sale price may differ from other indicators, such as fair market value (FMV), depending on the sale itself.
To calculate whether the entity realizes a capital gain or loss, subtract the property’s adjusted basis from its final sale price. If the result is positive, such as when selling a property for more than it was purchased for, it is considered a capital gain. If the result is negative, it is a capital loss.
What are Capital Gains Taxes?
All capital gains are taxable, whether realized by an individual, a corporation, a trust, a partnership, or another legal entity. The IRS defines two types of capital gains taxes: short-term and long-term. The difference between the two is based on the property’s holding period.
Short-term Capital Gains
Short-term capital gains on real estate are realized when selling property for a profit after holding it for one year or less. The tax rate for short-term capital gains is the same as the entity’s ordinary federal income tax rate. ordinary federal income. If you are an individual with short-term gains, then you will be taxed at your highest marginal rate, as it is included with your ordinary income.
For example, if a single-member LLC realizes a short-term capital gain on a real estate investment, it passes through the LLC to the owner. The owner must then report the gain on their personal tax return. The owner will pay capital gains taxes at the same rate as their federal income taxes as an individual, between 10 and 37%.
A “C corporation” realizing a short-term capital gain would typically be subject to capital gains tax at the same rate as its corporate income tax rate.
Long-term Capital Gains
Long-term capital gains are realized when selling a property for a profit after holding it for over a year. Individuals, partners in pass-through entities (e.g., partnerships, S corporations), and owners of disregarded entities (e.g., single-member LLCs) are subject to long-term capital gains taxes.
How are Long-Term Capital Gains Taxed on Exit for Individuals?
The tax rate for long-term capital gains depends on the individual’s taxable federal income and filing status. The most common long-term capital gains tax rates are 0%, 15%, and 20%.
However, these rates can change based on tax law revisions, and some additional factors may come into play to alter the taxability of these gains, such as the Net Investment Income Tax (NIIT) for certain high-income taxpayers. The NIIT is an additional 3.8% tax imposed on certain net investment income, including capital gains for individuals with modified adjusted gross income (MAGI) over $200,000 for single filers and $250,000 for married couples filing jointly.
0% tax rate. This tax rate applies to individuals with a taxable federal income of less than or equal to:
○ $44,625 for single and married filing separately
○ $89,250 for married filing jointly and qualifying surviving spouse
○ $59,750 as a head of household.15% tax rate. This tax rate applies to individuals with a taxable federal income of:
○ Over $44,625 but less than or equal to $492,300 for single
○ Over $44,625 but less than or equal to $276,900 for married filing separately
○ Over $89,250 but less than or equal to $553,850 for married filing jointly and qualifying surviving spouse
○ Over $59,750 but less than or equal to $523,050 for head of household.20% tax rate. This tax rate applies only to a portion of an individual’s long-term capital gains that exceed the income thresholds in the 15% tax rate bracket. Realizing long-term capital gains can increase your total taxable income and expose part of your gains to the 20% tax bracket.
For example, consider the owner of a single-member LLC filing as a head of household who typically falls under the 15% tax rate. If their total taxable income exceeds $488,500 after realizing a long-term capital gain, the portion of their gains pushing their income over this threshold will be taxed at 20%. As a tax planning strategy, the investor may choose to sell a portion of the investment or try to realize the gain over a longer period.
There are a few other exceptions where capital gains may be taxed at rates greater than 20%:
- The taxable part of a gain from selling Section 1202 Qualified Small Business Stock is taxed at a maximum 28% rate.
- Net capital gains from selling collectibles (such as coins or art) are taxed at a maximum 28% rate.
- The portion of any unrecaptured Section 1250 gain from selling Section 1250 real property is taxed at a maximum 25% rate. For example, if your company sells a rental property after claiming depreciation deductions, the IRS applies the 25% tax rate on the portion of the gains realized due to the depreciation deductions.
C corporations pay all capital gains taxes using the corporate income tax rate, whether they realize short-term or long-term gains. Such gain or loss is considered capital or ordinary, depending on the type of asset. However, a C corporation is subject to the same U.S. federal corporate tax rate on capital gains and ordinary income, which is currently 21%.
Ways to Limit Capital Gains on Investment Properties
Consult with your tax adviser such as Windes’s Real Estate Accounting Service so that they can assist you in identifying the best strategies for minimizing capital gains when you decide to exit an investment. Whether you are an investor, property partner, real estate developer, or manager, their dedicated team is ready to support you every step of the way when considering the impact of capital gains on the bottom line.
Your adviser will assess your unique tax situation, provide professional consulting services, deliver cost segregation reports and identify the most effective solutions to optimize your profits while minimizing tax obligations.
Reducing your capital gains tax liability primarily involves minimizing the realized capital gains from a sale. Common techniques for achieving this goal include using tax-deferred funds, leveraging primary residence exclusions, implementing tax-loss harvesting, and considering Section 1031 Like-Kind Exchanges.
Tax-Deferred Funds
Investing in tax-deferred accounts, such as an Individual Retirement Account (IRA) or a 401(k), can limit capital gains on a real estate investment. Many investors need to match gains with losses. Retirement accounts can hinder your ability to recognize a gain or loss to match it with other capital gains or losses. While this method is more commonly associated with securities, like stocks and bonds, it can also be used with Real Estate Investment Trusts (REITs).
REITs pool investments in real estate properties into a single account, which can be traded like stocks. Gains and income generated from these accounts are typically taxed once withdrawn, allowing you to defer taxes, giving you control over your real estate tax liability, and potentially reducing your immediate tax obligations. Because of this, many investors start an investment as a REIT instead of a separate legal entity that would be subject to capital gains upon sale.
Section 1031 Exchange
A Section 1031 Exchange, also known as a Like-Kind Exchange, is governed by Section 1031 of the Internal Revenue Code. Using this provision, investors can defer capital gains taxes from the sale of a property if they reinvest the proceeds into another like-kind property within a specific time frame. Effective January 1, 2018, IRC Section 1031 applies only to real estate assets.
- Defer capital gains. Defer capital gains taxes by reinvesting the proceeds into a similar, like-kind property. This deferral allows you to preserve your investment capital and potentially increase returns.
- Multiple exchanges. You can continue to defer capital gains taxes by repeatedly using the Section 1031 Exchange method as long as you reinvest in additional like-kind properties each time.
- Reporting and compliance: Adhering to the rules and conditions outlined in the Internal Revenue Code is essential to qualify for a Section 1031 Exchange. Proper tax reporting and compliance with supporting documentation is also crucial.
Primary Residence Exclusion
As an individual investor without a legal entity to absorb expenses related to a real estate investment, the Primary Residence Exclusion, as outlined in Section 121 of the Internal Revenue Code, allows individuals to exclude up to $250,000 (or up to $500,000 for married couples filing jointly) of capital gains from the sale of their primary residence if they meet specific criteria.
- Primary residence requirement. To qualify for the exclusion, you must prove that you used the property as your primary residence. This can be demonstrated through tax returns showing the property’s address or utility bills for the home with the taxpayer’s name matching the property’s address.
- Two-year residency: You must have used the property as your primary residence for two years within the five-year period leading up to the sale. These two years do not need to be continuous; they can consist of separate one-year periods.
- Exemption amount: The maximum exemption amount is $250,000 for single filers and $500,000 for married couples filing jointly. If your capital gains exceed these thresholds, you will be subject to capital gains tax on the amount exceeding the exemption. The tax is levied on the gain and not the price of the house. All costs, including the home’s original price, are excluded from the gain, similar to gains on other capital assets.
Individual Strategies to Minimize Tax Liability on Real Estate Investments
Alternative strategies can minimize your overall tax liabilities on your primary residence, ultimately minimizing your individual tax liability. The three primary approaches to achieve this are depreciation deductions, itemized deductions, and asset capitalization to boost the basis of the property.
A sophisticated real estate investor wants to keep their expenses related to capital gains contained at the corporate or business entity level in order to realize all expenses before a tax event happens. This concept shields your potential income from double taxation.
Itemized Deductions
If you approached an investment as your primary residence, itemized deductions can help manage tax liability on your primary residence by limiting taxable income on your individual return. The tax code allows you to deduct specific expenses from your taxable income through Schedule A of the individual’s 1040 filing, reducing the taxes owed.
Typical itemized deductions related to your primary residence include:
- Mortgage interest. You may deduct the interest paid on a mortgage loan used to purchase, build, or improve a real estate property.
- Property taxes. Most real estate taxes paid on investment property are deductible in the same year you pay them. As of 2021, your deduction of state and local income, general sales, and property taxes is limited to a combined total deduction of $10,000 ($5,000 if married filing separately).
- Repairs and maintenance. If you operate a rental or income-producing property, you may deduct the costs of repairing and maintaining it in the same year they were conducted. Repairs and maintenance costs are typically only deductible if they are ordinary, necessary, and reasonable. The repairs must also not qualify as capital improvements, which may increase the building’s value and adjusted basis instead. Typical examples of deductible repairs and maintenance include fixing leaks in water pipes, restoring a deck, patching a damaged roof, or re-plastering and painting walls.
- Operating expenses. You may deduct the costs needed to operate real estate property. Examples include water, electricity, insurance, advertising, legal fees, property management fees, and other utilities.
Advanced Strategies within a Separate Tax Entity
Tax-Loss Harvesting
Tax-loss harvesting is the practice of intentionally selling investments at a loss. This strategy will result in capital losses, which can offset capital gains realized on other investments and reduce or neutralize your total tax liability for the same year. While this practice is rare in real estate investment, it can be a solution for some advanced investors, depending on the current market conditions.
For example, consider a situation where you own Building A, purchased for $1,000,000, and Building B, purchased for $1,200,000. If you sell both buildings for $1,100,000, you realize a capital gain of $100,000 on A and a capital loss of $100,000 on B. The losses offset the gains, neutralizing your capital gains tax liability.
Depreciation Deductions
Depreciation deductions allow real estate investors to account for the gradual devaluation of a property’s value over time due to wear, tear, or obsolescence.
While claiming depreciation deductions can reduce your current taxable income and lower your income tax liability, it will impact the tax basis of the property upon sale. When you eventually sell the property, part of your capital gains may be subject to a higher tax rate of 25% if depreciation deductions were claimed during ownership.
Capitalize Improvements to Boost Property Tax Basis
Property basis boosting is intentionally improving a property’s value and tax basis. Because capital gain taxes are calculated by subtracting the adjusted basis from the final sale price, increasing a property’s basis can reduce the taxes owed in future years.
Capital improvements to the property contribute to the tax basis of the investment. Typical improvements include additional rooms, major renovation work, structural enhancements, or installing energy-efficient upgrades.
This article is for informational purposes only, and is not a recommendation or offer to buy or sell securities. This content is intended for accredited investors only. Information herein may include forward looking statements and is for informational purposes only. Forward-looking statements, hypothetical information, or calculations, financial estimates and targeted returns are inherently uncertain. Past performance is never indicative of future performance. None of the opinions expressed are the opinions of RealtyMogul. Advice from a securities professional is strongly advised, and we recommend that you consult with a financial advisor, attorney, accountant, and any other professional that can help you to understand and assess the risks and tax consequences associated with any real estate investment. All real estate investments are speculative and involve substantial risk and there can be no assurance that any investor will not suffer significant losses. A loss of part or all of the principal value of a real estate investment may occur. All prospective investors should not invest unless such prospective investor can readily bear the consequences of such loss.