As discussed earlier in this article, selling your home can result in large capital gains that may incur high income tax bills. While it is important to report all of your real estate transactions, there are certain strategies you can use to avoid or reduce these taxes.
One of the most common ways to minimize or even eliminate potential capital gain taxes from a sale or exchange of your primary residence is by completing a qualified rental property transaction.
A qualified rental property transaction means transferring ownership of your house to a limited liability company (LLC) or individual for their personal use as a principal residence. This removes the asset status of the house and instead treats it like any other investment property.
This changes how we calculate gross sales for determining taxable profits. Since the house no longer has an “asset” value, there is not necessarily a built-in profit when calculating the price you sold it for. In fact, many sellers don’t realize they earn anything at all until they account for the costs of buying and then reselling the house!
Furthermore, if you live in the same state as where you owned the house, you may be able to exclude the cost of your new residence. You have to meet specific criteria, but being aware of this exclusion can save you lots of money in taxes!
There are also some less obvious deductions or credits that can lower your tax bill further.
Time is on your side
There’s no time limit for most people when it comes to paying capital gains tax, however, you should be aware of how long you have before you need to pay taxes on real estate.
If you are in fact due a refund from other sources such as income or inheritance then you can wait to see if those get sent through first!
But otherwise, there’s never really an ideal time to sell unless you’re trying to avoid having a big loss. The best way to minimize your taxable gain is to pick a day that works well for you and do your best to stick with it, but also understand that this may not be possible.
Stay consistent
The main reason people have capital gains is because they’re selling or letting go of their property, so it makes sense to keep spending money on your house steady before you add sale or rental activity into the mix.
As we mentioned earlier, most people pay less tax when they sell an older home as opposed to buying a new one. This is because when they originally owned the home, they paid lower rates due to being in the early stages of paying off their mortgage.
Now that they own another house, they can deduct the cost of both mortgages from each other, effectively reducing how much taxable income they make.
This article will talk about some strategies for keeping up stable monthly payments on your current residence, but first let us discuss what happens if you decide to pull out and sell at a later date.
Know your tax rate
As mentioned earlier, what kind of capital gains you realize depends not only on the property, but also how it is sold. If you are in the 25% or lower income bracket, you will probably want to keep the property as long as possible before selling so that you can avoid paying higher taxes on the profits.
However, if you are in the highest marginal tax bracket (above 40%), then you should consider whether or not it makes sense to hold onto the property longer. You may be able to offset some of the losses with other deductions and credits, which could reduce your overall taxable income enough to fall into the lower-taxed area.
Furthermore, even if you are in a slightly less expensive tax bracket, you might still have access to special programs or loopholes that reward or eliminate tax liabilities for certain types of real estate sales. For example, there are ways to pay no federal income tax on the profit when you sell an apartment, house, or business property.
Create an estate plan
Even if you’re not planning to pass away anytime soon, it is still important to have an estate plan in place. This can include having a will, trusts, life insurance policies, and other legal documents that manage your wealth after you die.
By having these pieces in place, your loved ones are informed about who gets what and how to distribute your assets.
There are some simple ways to reduce capital gains tax when real estate goes up in value. Some of these strategies are mentioned below!
Avoiding capital gain taxes through inheritance
It is possible to avoid paying any additional capital gains tax by passing along your property to family members.
This can be done through outright gifts or via trust structures. However, there are limitations to this kind of gift. For example, you cannot give more than $14,000 per person per year directly from yourself to another individual without using a trust.
Furthermore, if you use trusts to benefit your children, you may face higher income tax depending on the situation. This could easily negate the benefits of the gift.
Do not sell for less than your purchase price
There is no good reason to try to avoid paying capital gains tax by selling an investment property for less than what you paid for it.
This can backfire in many ways.
For one, the IRS may decide that you are avoiding taxes by writing off the difference between what you sold it for and how much you paid for it. They will also likely consider this a way to dodge income tax because you sold it for less than what you paid for it.
Furthermore, if you do manage to pull off this trick, you have just wasted your money.
Stay clear of short sales and foreclosures
There are two main reasons why people create what’s called a “short sale” in real estate. The first is to avoid foreclosure, which can hurt your credit if it goes into default.
The second is to get out from under an investment that has lost value. By selling as a short seller, you’ll probably make a little bit less than you would have buying it at full price, but not much — and you’ll also keep the property.
There is one situation where a short sale may be appropriate, though: when you owe more money than the property is worth.
Transfer to a family member
One of the biggest ways to avoid capital gains tax is by transferring your property to someone you trust, or who trusts you. This could be a friend, relative, business partner, or even yourself!
By using this strategy, as long as you have provided them with all necessary documents and proofs, they can then sell the asset without having to pay any taxes. They are also free to keep the money they make from selling it.
This way you get to save lots of money in income tax, while at the same time protecting your legacy (future inheritance).
You will need to ensure that the person you gift the house to does not live far away so you do not lose contact with them. It should be made clear how much the house costs so there is no argument over the price later if they try to resell it.
Inter-generational transfers are great because it keeps relationships strong, which we all know is important for happiness.
Capital gains tax is based on your location
The other major way to reduce capital gain taxes is by choosing to live in or invest in lower-taxed areas. This is known as taxation differential. A low income tax rate may be due to the area being less wealthy, or because of government budget cuts for education, healthcare, and transportation.
If you choose to reside in an expensive city, you will likely have higher capital gains taxes than someone who chooses to live in a more modest place. The same goes for investing in high cost property – they could potentially add to your taxable income.
On the other hand, if you choose to live in a poor area, there can be health issues related to lack of resources and safety, which can prevent people from accessing good quality healthcare.
