7 Ways to Lower Capital Gains Taxes on Real Estate

Posted by Matt Lee on Jun 3, 2022 11:25:09 AM

Investment properties come with a slew of tax advantages.

From property depreciation to deductions, landlords have many ways to lower their taxes while owning property. But what about when it comes time to sell?

Uncle Sam hits you with capital gains tax on your profits when you sell a property. So long as you owned the property for at least a year, you pay the lower long-term capital gains tax rate, ranging from 0-15% for middle-income Americans and 20% for high earners.

Even so, you may not have to pay that either.

Try these ideas for reducing your capital gains taxes on real estate — or avoiding them altogether.

1. Live in the Property for 2 Years

If you’ve lived in a property for at least two of the last five years, you qualify for the primary residence exclusion, also known as a Section 121 exclusion. You pay no capital gains taxes on the first $250,000 of profits from the home sale, or $500,000 if you’re married.

So, even if you bought the property as a rental initially, you can move in for two years and then sell in order to qualify for the exclusion.

Alternatively, you can buy the property as a primary residence, using a cheaper conventional mortgage rather than a hard money loan or rental loan, and then move out after two years of living in it. You can then keep it as a rental property, but you’d have to sell within three years of moving out if you want to qualify for the exclusion. As an added perk, this strategy lets you buy the property with a low down payment.

2. Meticulously Document Every Improvement

When you make “capital improvements” to an investment property, it raises your cost basis. That means you can subtract these repair costs from your sales price, along with the original purchase price, when you calculate your capital gain after selling the property.

The line can get blurry between maintenance, damage repairs, and capital improvements however, so speak with an accountant when you add up your capital improvements over the years. Regardless, you still want to keep meticulous records of all maintenance and repair costs. While repair costs don’t lift your cost basis, you can deduct them each year from your taxable cash flow.

3. Sell After You’ve Taken Other Losses

Losses on other long-term investments can offset your gains from selling a rental property.

For example, if you took losses on stocks this year, it’s a good year to sell your property, at least from a tax perspective. Just don’t slaughter the golden goose only to avoid a little money on taxes, and remember that you can carry losses forward to future years.

You can also try tax loss harvesting. It involves selling assets for a loss then immediately re-buying similar (but not too similar) assets, so you can rack up the capital losses to offset your gains. For example, during a stock market crash, you could sell your shares in a small-cap index fund then immediately use the money to buy shares in a mid-cap fund. The losses you take can then offset your capital gains from selling real estate.

4. Invest with a Self-Directed IRA

Sure, you can invest in stocks through a standard IRA at your investment brokerage. Or you open a self-directed IRA and use it to invest in real estate.

In particular, you’d want to open a self-directed Roth IRA, so you pay no taxes on your gains.

That could include flipping houses, which is a great way to build up your IRA balance quickly. When you get sick of swinging hammers, you can then switch to a more hands-off buy-and-hold strategy. If the day comes when you sell properties owned by your self-directed Roth IRA, you won’t pay capital gains taxes on your profits.

At least for the portion of the property that you used your cash IRA balance to buy. If you financed the property with a loan, that portion doesn’t get IRA tax protections.

5. 1031 Exchanges

Tax law lets you take your gains from selling an investment property and immediately reinvest them in another property, without paying capital gains tax on your profits.

It’s called a 1031 exchange, and you can theoretically do it indefinitely. Each time you sell a property, you can turn around and use the proceeds to buy a bigger property that generates more cash flow. You still owe capital gains tax if you sell a property without replacing it, but rental cash flow makes for great retirement income. If you never sell the last property in the chain, you never pay capital gains taxes on any of the earlier property links in it.

6. Borrow, Don’t Sell

People sell properties because they want to cash out the equity. But you can also cash out equity by borrowing against your property rather than selling it.

Imagine you buy a rental property with a mortgage, and over the next few decades your tenants pay off the mortgage for you. After paying it off, you could just take out another rental property loan and do it all over again.

While you couldn’t borrow the entire value of your property, you can still cash out most of the property’s equity. All without having to give up the property — you’ll continue collecting rents and earning cash flow each month.

7. Die Owning the Property

By combining 1031 exchanges and borrowing rather than selling, you don’t ever have to sell the property. Which means you never have to pay capital gains taxes on it.

When you kick the proverbial bucket, the cost basis of your property resets to its current value. That wipes the slate clean of all capital gains.

Granted, if your estate exceeds the estate tax exemption ($12.06 million in 2022), your heirs may owe estate taxes on the overage. But otherwise, you get to enjoy rental income in retirement, borrow against the property to cash out equity if you like, and pass properties to your children with no one ever having to pay capital gains taxes. Still, inherited homes can come with other headaches for your children, such as probate, so get strategic in your estate planning.

Final Thoughts

You have plenty of options to reduce or avoid capital gains on real estate. And that says nothing of other tactics to reduce your taxes, such as rental property depreciation .

But before you take too many liberties with your tax bill, speak with an accountant who specializes in working with real estate investors. They’ll tell you not only what’s legal, but also how to avoid an audit, and what documentation you should keep handy in case you do get audited.

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