Capital Gains Tax and Real Estate: What You Need To Know

Real estate investors often face substantial capital gains taxes when selling properties. However, several strategies can significantly reduce or defer these taxes. This summary outlines key methods, including the Section 121 exclusion, 1031 exchanges, charitable remainder trusts, qualified opportunity funds, and donor-advised funds.

Section 121 Exclusion

The Section 121 Exclusion provides a substantial tax break for homeowners selling their primary residence. This provision allows for the exclusion of up to $250,000 of capital gains on the sale of a home ($500,000 for married couples filing jointly). To qualify, the following conditions must be met:

– Ownership Test: You must have owned the home for at least two years.

– Use Test: The home must have been your primary residence for at least two of the last five years before the sale.

– Frequency: The exclusion can be used once every two years.

This exclusion is particularly advantageous for individuals who have lived in their homes for a long time and have realized significant appreciation.

1031 Exchange

A 1031 Exchange, named after Section 1031 of the Internal Revenue Code, allows for the deferral of capital gains taxes on investment properties. This strategy involves reinvesting the proceeds from the sale of a property into a new, “like-kind” property. The main advantages and requirements include:

– Like-Kind Requirement: Both the sold and the purchased properties must be similar or character, though they do not need to be identical (e.g., exchanging a rental property for another rental property).

– Identification and Purchase Timeline: You must identify potential replacement properties within 45 days of selling the original property and complete the purchase within 180 days.

– Qualified Intermediary: The transaction must be facilitated by a qualified intermediary to ensure compliance with IRS rules.

This method is useful for investors looking to upgrade their property portfolio without incurring immediate tax liabilities. Many serial real estate investors utilize this technique over and over while eventually leaving their portfolios to heirs. This can eliminate capital gains taxes when the heir inherits the properties upon death and receives a step-up in basis on the property.

 Charitable Remainder Trusts (CRTs)

A Charitable Remainder Trust (CRT) is an estate planning tool that allows individuals to donate appreciated real estate (or many other assets) to a charitable organization while receiving a charitable deduction and deferring capital gains taxes. Here’s how it works:

– Creation: The property is transferred to a CRT, which then sells the property without incurring capital gains tax. This is because the trust sells the property and is exempt from the capital gains taxes on the property. 

– Income Stream: The donor receives an income stream from the CRT, either for a specified term or for life.

– Charitable Deduction: The donor receives a charitable deduction based on the present value of the remainder interest that will eventually go to the charity.

– Remainder to Charity: After the term of the trust ends, the remaining assets are transferred to the designated charity.

CRTs benefit donors who wish to support charitable causes while benefiting from tax savings and an income stream. This strategy requires careful consideration and consultation with an estate attorney and financial planner to determine if it is right for you. 

Qualified Opportunity Funds (QOFs)

Qualified Opportunity Funds are investment vehicles designed to spur economic development in designated low-income communities. Investing in a QOF can offer significant tax benefits:

– Deferral of Gains: Capital gains invested in a QOF can be deferred until the earlier of the date the investment is sold or exchanged or December 31, 2026.

– Exclusion of Gains: If the investment in the QOF is held for at least 10 years, any additional gains from the QOF investment are excluded from tax.

-Eligibility: Investments must be made in qualified opportunity zones, which are designated low-income communities.

QOFs are advantageous for investors seeking to reduce their tax liabilities while contributing to community development. The rules regarding the use of QOFs are complex and require collaboration and communication with tax professionals. 

See the IRS regulations governing this here: https://www.irs.gov/credits-deductions/businesses/invest-in-a-qualified-opportunity-fund

Donor-Advised Funds (DAFs)

A Donor-Advised Fund (DAF) allows individuals to make charitable contributions while receiving an immediate tax deduction. For real estate, a DAF can be used as follows:

– Contribution: Real estate is donated to a DAF, which sells the property and does not pay capital gains tax on the sale.

– Immediate Deduction: The donor receives an immediate tax deduction based on the fair market value of the property at the time of donation.

– Grant Distribution: The donor can advise on how and when the funds should be distributed to charitable organizations.

DAFs are flexible and allow donors to support charities over time while receiving upfront tax benefits; however, it should be noted that this strategy cannot be used to recapture and utilize the proceeds of a real estate transaction for income purposes. 

Financial Planning Example

Joe, who is 60 years old, has a real estate investment property worth $500,000 for which he paid $250,000. His gross income puts him in the 15% capital gains bracket. He held the property for more than one year but did not occupy it, so he will be subject to a long-term capital gain of $250,000, triggering $37,500 in capital gains taxes. Joe is very charitably inclined, has a sizeable pension, a large IRA, and wants to execute a glide path to retirement at 65 by working less hours and living on less between age 61-65. The proceeds from his home sale are not needed for him to meet his goals in retirement based on the other assets that he and his wife have acquired. He currently works for a very large company in management and has an adjusted gross income of $300,000. He is concerned about taxes in retirement and his wife also has a large IRA that they think will be problematic for their tax liability long term.

Strategy: Joe decides to establish a Donor Advised Fund and donates his real estate proceeds to the DAF for a total of $500,000 at sale. He is able to deduct up to 30% of this based on his AGI ($90,000) in his last year of high pay to help with taxes and the remaining donation amount carries over for 5 years. He would then deduct the full amount ($410,000) over the next 4 years at 30% of each year’s AGI (as they execute the glidepath). Meanwhile, the full amount of the DAF at $500,000 is distributed to charities of his choice as directed. During the years of deduction, Joe could implement Roth conversions during the years of 61-65 and offset some tax liability with his deduction to the DAF. This would set him up for a retirement with less taxes, meet his giving goals, and provide him peace of mind as he enters retirement. 

*The example above is for educational purposes and should not be considered specific tax, financial, or legal advice. Please consult with your financial planner or other appropriate professionals.  

Conclusion

Minimizing or deferring capital gains taxes on real estate involves strategic planning and utilizing various tax-efficient tools. The Section 121 exclusion offers a significant tax break for primary residences, while the 1031 exchange facilitates the deferral of taxes through reinvestment in like-kind properties. Charitable remainder trusts and donor-advised funds provide avenues for supporting charitable causes while achieving tax benefits. Qualified Opportunity Funds offer tax incentives for investments in economically disadvantaged areas. Each strategy has nuances, and choosing the right approach often depends on individual circumstances and goals. Consulting with a tax advisor or financial planner can help tailor these strategies to fit specific needs and maximize tax benefits.