Real estate is a nearly $4 trillion dollar asset class in the U.S. That’s about 5% of all household assets. And for many Americans, it plays an even bigger role: their house represents the majority of their wealth. It is also a popular asset for seasoned pros and new investors alike, and for good reason: the barriers to entry are low and it is an asset class that has a reputation for growing consistently. So, given the situation, how can you avoid capital gains tax on real estate?
Additionally and in contrast with other types of assets, there are a number of viable tax planning options for real estate. Each strategy has merits and drawbacks depending on the asset’s past appreciation, your investment preferences and future growth expectations. Ultimately you get to decide, regardless of which you choose just know it is critical to understand and take advantage of the unique tax-advantaged structures available.
Capital Gains Tax on Real Estate
Valur’s goal is to help people keep more of their hard-earned gains by taking the sophisticated tax mitigation and asset protection tools of the ultra-rich and making them seamless and accessible to everyone.
Below, you will find a summary of many of the common tax-advantaged structures, an in-depth explanation of each including their associated tradeoffs and common situations when they are used.
|Structure||Personal Residence Exemption||Charitable Remainder Trusts||Installment Sale||1031 Exchange||Opportunity Zone|
When is this used?
|After selling your personal residence||Before the property is sold||Before selling your property||Immediately after selling your property||After an asset is sold but within 180 days of the sale|
|What can you invest in?||Any asset||Any asset||Debt and real estate||Real estate||Real estate|
Primary tax benefit
|Individuals can exclude up to $250k (or $500k for a married couple) of capital gains from taxes||Defer federal and state taxes on the property sale||Spread out your tax burden over the length of the loan||Defer capital gains taxes on the property sale||Defer taxes on capital gains income until 2026; avoid taxes on further gains from OZ investment (if held for 10+ years)|
|100% up front||Can receive a % of the trust assets every year or defer the distributions||Payments are spread over many years||No liquidity until the sale of the second property||Typically no liquidity for at least 5 years and potentially 10 years|
|If your capital gains are significantly larger than your exemption, you can still face a big tax bill||Don’t have access to all the sale proceeds upfront||Credit risk, concentrated investments||Your investment is concentrated in a single property||Your investment is concentrated in a single asset class and geography and in a limited number of properties|
What is the Primary Residence exclusion?
The Primary Residence exclusion is a rule that allows people to exclude up to $250k for single filers or up to $500k for married filing jointly in capital gains tax from the profit they make on the sale of their home.
This rule is one of the easiest ways to reduce or eliminate capital gains taxes when selling your home and in particular, you’ll be eligible for this exclusion if:
- You owned and used the property as your primary residence for two out of the five years immediately preceding the date of the sale.
- You haven’t taken a capital gains exclusion for the sale of any other property for at least two years before this sale.
- You’ve owned the property for at least five years prior to the sale.
The benefits of the personal exemption come down to convenience: It is a simple process — just a deduction on your tax return— and you’re not restricted in how you can use the proceeds from the sale.
What is the key tradeoff?
Taking the personal exemption is generally a no-brainer (if you qualify) unless your capital gains are significantly larger than your max exemption of $500k. If you do have more gains than the exemption covers, you could still face a big tax bill and it could be worthwhile to investigate other options.
Selling your real estate in a Charitable Remainder Trust
A Charitable Remainder Trust (also known as CRT) is a tax-exempt account similar to an IRA. It is often used to sell appreciated assets because of its tax advantages. At a basic level, the key benefits of a Charitable Remainder Trust are simple:
- Tax deferral: Avoid paying taxes upfront when you sell assets in the trust and instead reinvest those saved tax dollars to make the same investments you would otherwise make
- Tax free growth: You can grow your investments tax free inside of a CRT
- Reduce taxable income: Receive an upfront charitable deduction to reduce your taxable income, typically about 10% of the value you put in the trust
What Are the key trade offs?
- Up-front liquidity: You can only withdraw a percentage of trust assets every year.
- The transfer of assets to the trust is irrevocable, which means you cannot change your mind about the arrangement after it has been set up.
If you are considering using a CRUT, you should gift the property before agreeing to sell it and make sure that it is free of debt.
Using an Installment Sale
An installment sale is a sale of property in exchange for a loan when you only report part of your gain when you receive each loan installment payment.
Say you sell a property for a $250k profit. If you file your tax return with an extra $250k in taxable income in a single year, you can expect to pay taxes on it that year.
If you don’t want to pursue a tax-exempt trust, you can use Installment Sale instead to spread the profits over many years. Essentially, you offer the buyer an installment plan, they will pay you a down payment this year and then pay off the remainder of the sale price over time. If the payments are spread out over a long period, you can reduce your marginal tax rate significantly, plus, you get to charge the buyer interest.
As you may imagine, there are some risks involved with this alternative:
- Credit risk: The buyer may fail to make the installment payments and you have to manage the overhead of collecting from the buyer
- You are receiving smaller payments over time, so you won’t be able to reinvest the proceeds and capture potential additional investment growth.
- You aren’t diversifying your investments, and can’t redeploy your capital into assets that might grow faster than the interest rate you are charging over the course of the installment period.
Using A 1031 Exchange to Roll Over Your Estate Investments
A 1031 exchange is a real estate investing tool that allows investors to swap out an investment property for another and defer capital gains that they would otherwise have to pay at the time of sale on the first property.
As a result, real estate investors are able to get out of underperforming assets, sell a property whose value is inflated, or simply sell when they want all without worrying about the immediate tax implications as long as they roll the sales proceeds into a similar property.
As an example, Say you buy a property for $2M and sell it for $3M for a $1M profit. You could pocket that $1M and then pay income taxes on it or you could immediately invest it in another property and pay no taxes on it until you ultimately sell the second property.
How does A 1031 exchange work?
First thing to take into account is that the property you’re selling and the property you’re buying must be “like-kind,” which means they must be similar but not necessarily the same quality or grade. You must then work with a qualified intermediary, also known as an exchange facilitator, who holds your funds in escrow for you until the exchange is complete. Finally, you’ll have to tell the IRS about your transaction, where you’ll describe the properties, provide a timeline, explain who was involved in the process and list the money involved.
What Are the Key Tradeoffs?
- You do not gain any liquidity until you finally sell the last acquired property and cash out.
- You have to continue to reinvest in real estate and can’t diversify your investments.
Please visit our article to better understand how 1031 Exchanges work and their benefits
Invest in Opportunity Zone funds
Opportunity Zones are an economic development tool that allows you to invest in underinvested areas in the United States while gaining tax benefits. Investments in Opportunity Zones are eligible for preferential tax treatment if they are made through a Qualified Opportunity Fund (QOF).
These structures can be a good fit if you have already realized a big capital gain. If you roll your eligible realized capital gain into a Qualified Opportunity Fund within 180 days of realizing the gain, two forms of tax incentive are available:
- Tax deferral: Capital gains rolled into a QOF may be deferred until the investment is sold or exchanged, or the end of 2026, whichever comes earlier.
- Basis adjustment: If you hold the QOF investment for at least 10 years, you can avoid taxes entirely on the sale of the Opportunity Zone investment.
What are the downsides of Opportunity Zone Funds?
- Higher fees vs traditional investments (typically at least 1.5% annually)
- A long period of illiquidity: money has to stay in a QOF for at least five years from the fund close to realize the tax reduction benefits and ten years from the fund close to realize the basis adjustment benefit.
- Exposure to concentrated assets.
- As this is a new asset class, we haven’t seen the returns from and full fund life cycles so it is hard to know what the actual returns could be.
Let’s now take a look at an example to evaluate each of these tax planning structures based on post-tax return on investment after 20 years.
Like a lot of our clients, Bryan and Hannah are planning to sell a property. They are both 35 years old, married and based in California. The selling price is $5M with a $1M cost basis and they expect to be hit with a 37% tax rate (because all of their earnings will be long-term capital gains).
As a result, they would owe around $1.5M in state and federal taxes on their sale (37% of their $4M capital gain).
For the example, let’s assume the stock market will grow 10.5% annually (based on historical S&P returns), while an opportunity zone and a 1031 investment might appreciate 9% annually (based on historical REIT returns).
What would all of these tax savings mean for Bryan and Hannah’s bottom line after 20 years?
As you can see, there is no one-size-fits-all solution, the returns from each strategy are relatively similar, but MUCH better than not using any tax mitigation structure when selling and having reinvested the remainder in a regular, taxable investment account.. This means that your goals and assumptions about the future are critical when deciding which solution best fits you.
So when would each structure make sense? We’ve made a post about it (and we encourage you to read it), but a summary of it would be the following:
The Primary Residence Exclusion is the easiest win if you’re selling your primary residence and your property qualifies. If your gains are lower than the exemption, you can claim this deduction — it’s a no brainer.
If the gain is significantly higher than your exemption or your property does not qualify, then it may make sense to look at the other alternatives:
- Charitable Remainder Trusts: ideal If you are interested in reinvesting the proceeds in a diversified portfolio of assets outside of real estate and you don’t need access to all of the proceeds from the sale immediately. If you’d like to understand if a CRUT or the Primary Residence Exclusion is better for your situation, please read this article and its example about the topic and use our calculator to compare the returns between using a CRUT, personal exemption or doing nothing!
- Installment Sale: might be a good fit if you are not worried about the buyer’s credit risk, can manage the additional overhead of collecting on a loan and managing the related accounting and tax work and are essentially reinvesting your sales proceeds into debt tied to your original property.
- 1031 Exchange: good fit when you want to sell your property and reinvest the proceeds directly into additional real estate that is for business or investment purposes.
- Opportunity Zone Funds: ideal when you want to sell your property and reinvest in more real estate without the overhead of managing the real estate yourself, as Opportunity Zone investments are typically done through an established institutional fund. You’ll also have to accept no liquidity for a few years.
We built a platform to give everyone access to the tax and wealth building tools of the ultra-rich like Mark Zuckerberg and Phil Knight. We make it simple and seamless for our customers to take advantage of these hard to access tax advantaged structures so you can build your wealth more efficiently at less than half the cost of competitors. From picking the best strategy to taking care of all the setup and ongoing overhead, we make it easy and have helped create more than $500m in wealth for our customers.