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5 Tax-Advantaged Ways To Sell Real Estate

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, real estate plays an even bigger role: Their house represents the majority of their net worth. Accordingly, it is critical to understand — and take advantage of — the unique tax advantages available when you sell your real estate.

This article will help you get started, with a guide to the five biggest tax breaks for real estate, how to capitalize on them and the benefits and risks of each.

1. Leverage the IRS’s “primary residence” exclusion

Easy pickings first. By default, you’ll pay no capital gains taxes on some of the appreciation of your primary residence when you sell it.

Under the so-called “Section 121 exclusion,” Individuals can exclude up to $250,000 of capital gains, while a married couple can exclude up to $500,000, provided that they meet certain criteria. In particular, you’ll be eligible for this exclusion if (1) you owned and used the property as your primary residence for two out of the five years immediately preceding the date of the sale; (2) you haven’t taken a capital gains exclusion for the sale of any other property for at least two years before this sale; and (3) you’ve owned the property for at least five years prior to the sale.

Bottom line: This is an easy win if you’re selling your primary residence and you’ve lived there for a decent stretch. If you can’t take advantage of this opportunity or your gains exceed the exclusion amount, though, it’s worth looking into the tax-saving opportunities that follow.

2. Sell via a Charitable Remainder Trust

With a Charitable Remainder Trust (CRUT), you can sell your highly appreciated real estate and pay no taxes today.

How does it work? You start by deeding your property to the trust (of which you are in control as trustee and beneficiary). Then, when you’re ready, you sell the property. The CRUT is a tax-exempt entity, so it (and you) will owe no taxes when you sell any appreciated asset, including real estate, via the trust. You get to reinvest all of the proceeds from your sale, instead of sending a large chunk to the federal and state governments. You’ll receive annual distributions from the trust, and when the trust ends, whatever is left goes to a charity of your choice.

Overview of how a Charitable Remainder Trust works

If the Section 121 exclusion doesn’t solve all of your tax issues, consider checking out our CRUT explanation. And if you’d like to learn even more, take a look at a customer case study and our calculator, with which you can estimate the expected return on investment from a CRUT.

When might a CRUT make sense for a real estate sale?

  • If the primary resident exclusion doesn’t apply to your property, or doesn’t cover the majority of your property’s appreciation
  • If you are interested in reinvesting the proceeds in a diversified portfolio of assets outside of real estate (and, therefore, other real estate-focused tax breaks don’t apply)
  • You don’t need access to all of the proceeds from the sale immediately

What are the key tradeoffs?

  • Up-front liquidity: You can only withdraw a percentage of trust assets every year — typically between 5 and 15% of the trust’s value, according to an IRS-approved formula

3. Use an installment sale

Say you sell a property for a $250,000 profit. If you file your tax return with an extra $250,000 in taxable income in a single year, you can expect to pay taxes on it now. There are two problems with that approach: You will you owe those taxes very soon — this coming April — and your effective tax rate will be much higher than usual because you have much more taxable income, all realized this year.

There is an alternative, though, even if you don’t want to pursue a tax-exempt trust: You can use what’s called an “installment sale” to spread the profits over many years. How this works is that you offer “seller financing” — essentially, you offer the buyer an installment plan, and they pay you a down payment this year and then pay off the remainder of the sale price over time.

Critically, with an installment sale, you only have to pay income taxes on the amount the buyer pays you in a given year. 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.

There are two main risks: First, you are becoming a lender. If the buyer fails to make the installment payments, you may have to foreclose on the property, and you likely won’t recover everything you’re owed. And second, you are receiving smaller payments over time, so you won’t be able to reinvest the proceeds and capture additional investment growth (though you will get those interest payments, which can make up for at least some of that growth).

When might an installment sale make sense for a real estate sale:

  • If the primary resident exclusion doesn’t apply to your property, or doesn’t cover the majority of your property’s appreciation
  • You are not worried about the buyer’s credit risk and can manage the additional overhead of collecting on a loan and managing the related accounting and tax work
  • You don’t need access to the majority of the proceeds up front

What are the key tradeoffs?

  • Credit risk: You are effectively taking on lender risk, plus additional work that most individuals aren’t used to managing
  • You need the buyer to cooperate and use your financing
  • It means you aren’t diversifying your investments, and you can’t redeploy your capital into assets that might grow over the course of the installment period

4. Roll your investment over with a 1031 Exchange

The “1031 exchange” is a tax planning strategy that allows you to sell an investment property, roll the proceeds into another property, and defer any capital gains — and the associated taxes you would have owed. As a result, real estate investors are able to get out of underperforming assets, sell while property values are inflated, or simply sell when they want , all without worrying about the immediate tax implications.

As an example, Say you buy a property for $100,000, spend another $20,000 on improvements, and sell it for $150,000 for a $30,000 profit. You could pocket that $30,000 and then pay income taxes on it. Or you could invest it in another property and pay no taxes on it until you ultimately sell the resulting properties and diversify.

When might a 1031 Exchange make sense?

  • If the primary resident exclusion doesn’t apply to your property, or doesn’t cover the majority of your property’s appreciation
  • You want to sell your property and reinvest the proceeds directly into additional real estate

What are the key tradeoffs?

  • You do not gain any liquidity until you finally sell the resulting property and cash out
  • You have to continue to reinvest in real estate and can’t diversify your investments outside of real estate

5. Invest in Opportunity Zone Funds

In 2017, the U.S. government designated many distressed areas as Opportunity Zones in an effort to drive investment in housing, small businesses, and infrastructure in those regions.

When you invest in Opportunity Zones with the capital gains from the sale of a property, you can take advantage of a number of tax benefits, including complete tax deferral until 2026, a tax rate reduction of between 10 and 15%, and full tax exemption on gains that happen within the Opportunity Zone investment.

When might an Opportunity Zone investment make sense?

  • If the primary resident exclusion doesn’t apply to your property, or doesn’t cover the majority of your property’s appreciation
  • You want to sell your property and reinvest in more real estate without the overhead of managing the real estate yourself. (Opportunity Zone investments are typically done through an established institutional fund

What are the key tradeoffs?

  • You do not gain any liquidity up front
  • You have to continue to reinvest in real estate — in specific distressed areas, to be precise — and can’t diversify your investments
  • Opportunity zones are a new investment class with uncertain returns and concerns that the asset class has been over-invested in

Conclusion

Real estate is a critical source of wealth building for many American families, and it offers many tax advantages. In our next article, we’ll take a look at a case study, looking more closely at the financial impact of each of these strategies can have on the sale of real estate.

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