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Eric Beise | Realtor

If you have held rental real estate for the past few years, you likely have seen your properties significantly
increase in value. This is a fantastic place to be! For various reasons though, you may now be looking to cash
out, upgrade, or get out ahead of some potential future increases in tax rates.
You may be wondering if there are any ways to legally avoid paying tax on the massive gains in your real
estate portfolio. Fortunately, the answer is yes! There are actually quite a few ways to legally avoid paying
capital gains tax. This post will highlight seven different strategies that may be particularly relevant to you.
To briefly define our terms, a capital gain is the technical name for when a property has appreciated in value.
The gain is calculated as the fair market value above and beyond your basis. The term basis basically means
the price you paid, plus any capital improvements, minus any depreciation you have claimed. If you sell a
property for $500,000 with a basis of $300,000, you will have a capital gain of $200,000 and this is the amount
that ordinarily would be subject to tax.

Use a 1031 exchange
One of the greatest tax deferral strategies available to real estate investors is the 1031 exchange. This feature
of the tax code enables someone to sell a property and then reinvest the proceeds in a qualifying replacement
property without paying any tax. It does require the use of a 1031 intermediary and some planning in advance
but is a common and powerful tactic for investors to use. Getting to reinvest the full proceeds from a sale into a
new property enables you to earn much higher returns on investment over time.

Keep records of capital improvements
Another strategy to reduce your capital gains tax is to simply keep good records of any capital improvements.
While small repairs can be immediately expensed to reduce your taxable income in a given year, larger
improvements must be spread out over time. Therefore it is important to keep good records to get your full tax
benefit every year and when you go to sell the property later. These costs are added to your cost basis which
reduces the amount of taxable gain you will incur when you sell the property. A capital improvement like
replacing a roof on a larger property can easily cost tens of thousands of dollars. It is important to make sure
you get your full deduction on expenditures like this.

Hold properties for at least a year
While holding properties for over a year doesn’t exactly eliminate your capital gains tax, it does change the
nature of your capital gain. If you are flipping a property and buy and sell within a year, the gain will be a short-
term capital gain. This means it will be taxed at the (typically) higher ordinary income tax rates. Holding it for
longer than a year, means you will instead pay long-term capital gains rates which tend to be lower.

Sell assets in a low tax year
Under current tax law, the first $80,000 of long-term capital gains can be taxed at a 0% rate. Yes, ZERO
percent tax. The catch is that this is offset by other income you earn as well. Therefore, if you made $40,000 in
other income, only the first $40,000 of a long-term gain would be at the 0% rate. Therefore, if you are able to
sell a property during a year you have abnormally low income it could be particularly advantageous. Also, if
you are considering selling any other investments such as stocks or other properties that are currently worth
less than you paid, it may also be to your advantage to sell these in the same year as a property at a gain to minimize your overall tax burden. Capital losses can typically only offset $3,000 of ordinary income, but can
offset any amount of other capital gains. For example, if you sold a stock investment with a $50,000 loss, it
should completely offset a $50,000 gain you may realize from selling a property in the same year.

Move in for two years
Owner-occupying a property means you are partially eligible for the section 121 exclusion. This exclusion is
what normally applies when you buy and sell a house you live in. You are allowed to exclude up to $250,000 of
gain ($500,000 for a couple) when you sell your primary residence. The same rule applies if you are living in
one unit of a multi-family property. A portion of the gain can be excluded because you lived in it for at least two
years.

Gift Properties
A great way to avoid capital gains tax and also make an impact is to donate a property that has increased in
value. This allows you to permanently avoid paying tax on the growth. If you give the property to a friend or
family member, they will eventually have to pay the tax themselves if or when they sell, but they still probably
won’t complain! If you give the property to a charity, either directly or through a Donor Advised Fund, you may
also qualify for a significant charitable deduction.

Invest through a self-directed IRA
A final way to avoid capital gains tax is to hold real estate within a self-directed IRA. If you have funds in an old
401(k) or IRA, you can roll them over to a self-directed IRA custodian and use this account to purchase real
estate or invest in various real estate projects. Properties can be bought and sold within the IRA but all the
funds grow tax-free until they are distributed at retirement. If they are within a Roth IRA there is never tax due if
all criteria are met.

Disclaimer
None of this should be taken as tax, legal, or financial advice. Work with a CPA or other tax professional to
determine the applicability of these concepts to your situation. We simply hope this post helps spark some
great conversation that could save you tens or even hundreds of thousands of dollars of unnecessary tax.