Real Estate Tax Saving Opportunities That You Don't Want to Miss
There are certain opportunities to potentially save up to hundreds and thousands of dollars in taxes that are missed by many people simply because they aren't aware that they exist. One of my goals has always been to provide tax tips and awareness of tax strategies that are practical and useful, so while tax strategies relating to real estate aren't something most of us would be able to utilize on a daily basis, I still want to bring awareness to this due to the huge potential magnitude of tax savings should an opportunity arise. The purpose of this post isn't to provide you with technical details and explain all the intricacies of the tax rules (and there are a lot, which is why it's crucial to work with a tax adviser and real estate professional when dealing with real estate tax transactions), rather, it's to introduce you to strategies utilized by the savviest real estate investors, so that if you find yourself contemplating a real estate transaction you'll know to reach out to a tax adviser for consultation to see if and how you could best take advantage of the situation depending on your own personal circumstances.
Under U.S. tax rules, whenever you sell anything that has appreciated in value, the net gain is generally considered taxable. However, you may have heard about the primary residence home gain exclusion where, if you meet the requirements under "IRC (Internal Revenue Code) Section 121", you won't have to pay the capital gains tax on any profits up to $250,000 (or $500,000 if married) when you sell your home. Since the maximum tax rate on federal capital gains tax and California tax is 37.1% (federal capital gains tax rate = 20% + net investment income tax = 3.8% + California maximum rate = 13.3%), this exclusion equates to a tax savings of up to $92,750 (for an exclusion of $250,000) or $185,500 (for an exclusion of $500,000). If you're thinking of selling your home, make sure to work with a tax adviser and familiarize yourself with the rules to qualify for this exclusion, as it's basically a free tax giveaway that you should take advantage of if possible.
Refer to additional key requirements and rules on IRC 121 listed below.
Those of you who invest in real estate or own rental property may have heard of a 1031 exchange where you can sell property at a gain without incurring any current tax liability. According to IRC Section 1031, when you sell investment property and then purchase “replacement property” of equal or greater value in a “like-kind exchange”, you can defer payment of taxes on gains from the sale of the original property until you eventually sell the replacement property (or continue to defer payment by exchanging yet again). While a gain deferral is less advantageous than a gain exclusion since you’re still liable for paying taxes on deferred gains sometime down the road (unless you pass away, which is a concept out of scope of this post), it’s still better than having to pay the taxes immediately if you don’t need to liquidate. Don't forget that this gain deferral strategy is only applicable for investment or business-use properties, meaning the properties you sell and subsequently purchase must be used for investment/business purposes and not a principal residence.
Refer to additional key requirements and rules on IRC 1031 listed below.
Now that you know about these two key real estate tax strategies, there are many ways to utilize and maximize them to your advantage. For example, did you know that there's an opportunity to utilize both the gain exclusion (excluding $250,000/$500,000 of gain on sale of the property) AND the gain deferral (deferring any remaining gain from sale of the property) simultaneously on one property? You may want to consider this strategy if the value of your property has appreciated more than the $250,000/$500,000 gain exclusion amount and you’re in a position to convert your primary residence into a rental. In addition to other eligibility requirements under Sec 121 and Sec 1031, the following key conditions must be met to use this combined strategy:
- The property meets the definition of a "principal residence" - this means you lived in it as your main home at least 2 out of the last 5 years before the date of sale
- The property at time of sale is an investment property or considered a trade or business property - this generally means you’ve converted your home into a rental property or other type of investment property and therefore no longer live there
- You exchange the current investment property to another investment property and don’t intend to live there - this generally means you need to own another principal residence
If you find yourself in this situation or can position yourself to be in this situation, you could potentially save hundreds of thousands in taxes. Again, I want to reiterate that this strategy and all real estate strategies in general should be carefully planned, so it’s imperative that you consult with a tax adviser before you engage in any real estate transactions. I also highly recommend you work with a real estate professional who’s well versed in such tax strategies.
Below are some of the tax rules and requirements for the IRC 121 gain exclusion and IRC 1031 gain deferral. The points listed below are only few of the many complex requirements of the tax code. You must work with a tax adviser to determine eligibility based on your own personal circumstances.
Summary of IRC 121 Gain Exclusion Requirements:
- Taxpayer must own the property
- The property must have been used as your "principal residence" for at least 2 years during the 5 years prior to sale
- To satisfy the principal residence requirement, you must physically occupy the home
- Gain exclusion can generally be claimed only once every two years
- If you have a home office, gain associated with depreciation previously taken will still be taxed at 25%
Summary of IRC 1031 Gain Deferral/Exchange Requirements:
- Property sold and purchased must be for investment, or business use property
- 1031 Exchanges must be performed by a Qualified Intermediary (these are professionals who facilitate the transaction in accordance to IRC Sec 1031)
- Taxpayer can not receive or constructively receive proceeds upon sale
- Price of the replacement property must be equal to or greater than the relinquished property to be fully tax deferred
- Taxpayer must identify potential replacement properties within 45 days of sale
- Taxpayer must take possession of 1 out of the 3 identified properties within 180 days of the original relinquished property sale