Buying an investment property is a serious endeavor. Not only will you have to worry about the upkeep, maintenance, and collecting monthly rent from tenants, but youโll also have to consider some of the potential tax consequences.
Specifically, youโll want to consider the tax consequences resulting from a potential sale of an investment property.
Before you actually pull the trigger and sell your property, itโs important to understand the type of impact a property sale would have on your financial picture.
In this article, youโll learn the top 3 tax strategies that you need to know about before selling an investment property and potentially owing a tax liability worth thousands of dollars the following year.
Strategy #1: 1031 Exchange
A 1031 Exchange could work for you if you want to defer paying a tax liability.
A 1031 Exchange might be best for you if you own an investment property with a sizeable taxable gain (on which youโll have to pay capital gains taxes).
With a 1031 Exchange, you would sell your investment property, and immediately buy another investment property that is considered of like kind and equal or greater value.
Assuming you follow all rules and requirements to satisfy the 1031 Exchange, you can defer paying taxes on your capital gains.
While a 1031 Exchange is referred to as a โlike-kindโ exchange by the IRS, the term could be a little misleading since you donโt exactly have to exchange one single-family rental property for another single-family rental property.
To qualify for a legit 1031 Exchange, the term โlike-kindโ refers to a property with a similar nature or character to the original investment property that youโre selling.
Some examples of like-kind exchanges include:
- Multi-family real estate for an industrial building
- Office building for a single-family rental property
- Apartment buildings for a mall or shopping center
- Condominium real estate for a single-family property
In addition to the like-kind rule, there are also additional requirements, specifically pertaining to the timeline of the original property sale and the new property purchase, that you must fulfill to satisfy the 1031 Exchange.
The 2 key timelines you must observe when making a 1031 Exchange include:
Within 45 days of selling your original property, you must designate the replacement property in writing
You must finalize the purchase of the new property within 180 days of the sale of the old property
In addition to these key timeline rules, there are other guidelines youโll have to follow to successfully defer any taxes.
Thatโs why you should meet with your tax accountant who can help steer you in the right direction and guide you through a successful 1031 Exchange.
Strategy #2: Charitable Remainder Trust
Utilizing a Charitable Remainder Trust (CRT) could be a good option if youโre looking to avoid a tax liability stemming from capital gains.
A CRT might be best for you if you are charitably inclined and donโt necessarily need access to the gains generated from the investment property.
In this particular case, you can transfer the ownership of an investment property into a trust like a CRT before you actually sell the property itself.
Keep in mind that any contributions of property or assets to a CRT are irrevocable. This means that for the most part, once youโve titled assets in the name of the CRT, you cannot decide to switch ownership at a later date.
Furthermore, legally speaking, you donโt have control of your assets once they are placed in the name of the Charitable Remainder Trust.
Assuming you move forward with this strategy by placing the property within the trust, once the property is sold, any gains resulting from the sale are exempt from capital gains tax.
The gains are exempt because the assets within the CRT are ultimately designated to go to charity.
Moreover, you may also receive a partial tax deduction for any of the assets that you contribute to the CRT.
However, assuming you designate yourself as the trustee of the CRT, you can still maintain some minor control over the CRT itself.
For example, you can reinvest the proceeds of the property sale into income-generating assets or you could invest the sale proceeds into appreciating assets.
If you decide to build multiple streams of income within your CRT, then you could even receive income from the trust throughout your lifetime. Typically speaking, any payments from a CRT to a non-charitable beneficiary (like yourself) would be reported as taxable income.
Since CRTs are fairly complex tax planning tools and require a lot of upfront planning, these financial vehicles are typically a better match for anyone planning to make a substantial transfer.
So, before you start thinking about starting a CRT, make sure to ask your tax accountant and wealth advisor for guidance on whether this charitable vehicle is the right next step for you.
Strategy #3: Increase Your Cost Basis
Finally, increasing your cost basis on your investment property could work for you if you want to reduce your overall capital gains tax liability.
Your cost basis is essentially calculated as the initial value of an asset (so what you originally paid for an investment property).
However, a cost basis is also adjusted upward for home improvements that you make while you own the investment property.
In part, the IRS then calculates your capital gains tax liability by subtracting the adjusted cost basis (purchase price plus any capital improvements) from the current fair market value of your investment property.
The resulting number (assuming that itโs positive) will help determine your tax liability.
Increasing your cost basis might be the right strategy if you own an investment property that you plan to hold for the long term (so youโre counting on long-term appreciation to increase the value of your real estate) and your investment property has several upgrades it could use.
Some property improvements that could increase your cost basis (and thus decrease your potential capital gains tax liability) include the following:
- New roofing
- New flooring
- Any inspection fees
- Updating appliances
- Replacing old appliances (like plumbing)
The key is the keep a meticulous record of what you upgrade or replace.
For example, consider keeping a folder on your computer or phone thatโs dedicated to capturing snapshots of receipts.
These receipts can be very useful when you adjust your cost basis upward.
Also, make sure to always loop your accountant and/or wealth advisor into the picture so that they can help manage your financial plan as you go.
Closing Thoughts
If you plan to become (or already are!) a real estate investor, then you need to plan ahead.
As the saying goes, if you fail to plan, then you plan to fail.
And when it comes to real estate investing, failing to plan ahead when it comes to potential tax consequences related to an investment property sale can put a big dent in your overall financial picture.
Make sure to consider which strategy is the right one for you, whether itโs deferring, reducing, or simply avoiding taxable gains.
And before you tackle an investment property sale on your own, it is also critical to note that you should meet with your wealth team beforehand to review all of the tax and other financial factors that could impact your overall picture.
Your wealth team could include your wealth advisor, your accountant or CPA, and possibly even a legal team to help you close your real estate deal.
The most important advice here is to do your research before anything else.
