How to Defer and Reduce Capital Gains Taxes on Investments
The federal deficit is at an all-time high, and the government needs to find new ways to raise revenue. One of the main ways they do this is to increase taxes. In fact, according to the Bureau of Labor Statistics, about 40% of a person’s income goes to some form of taxes! Tax breaks and tax advantages are few and far between. So, when one comes along, it’s in your best interest to take advantage of it. There are several strategies you can use to defer, reduce, and eliminate capital gains tax on real property and other assets. 1031 Exchanges, Delaware Statutory Trusts, Opportunity Zone Funds, and Installment Sales are just a few options to discuss with a trusted financial advisor.
What Are Capital Gains Taxes?
Capital gains are the profits you make from the sale of a property or investment. If your property or investment has increased in value since you bought it, you’ll likely have to pay a capital gains tax. This usually falls within the 15-20% range.
There are two types of capital gains taxes, short-term and long-term. Short-term is defined as a property or investment held for one year or less, while long-term is anything over a year. Different rates apply to each.
Short-Term Capital Gains Tax Rates
If you hold a property or investment for less than a year before selling, your capital gains tax rate will be your marginal income tax bracket. Marginal tax brackets are the tax rates applied to your last dollar of income. So, if you’re in the 20% marginal tax bracket, you’ll pay a 20% capital gains tax rate on any short-term profits.
Long-Term Capital Gains Tax Rates
The long-term capital gains tax rates are 0%, 15%, or 20%, depending on your taxable income and filing status. They’re much lower than short-term rates because the government wants to encourage people to invest for the long haul.
How to Defer, Reduce, and Avoid Capital Gains Taxes
There are a few ways you can defer, reduce, or avoid your capital gains taxes. The best strategy will depend on the type of asset in question.
How to Defer Capital Gains Tax on Real Estate
In the crazy real estate market we’re in right now, it seems like you just can’t win. If you’re selling property, you’re likely getting a great profit. However, you’re also setting yourself up for a huge tax. Luckily, there are tax planning strategies you can use to protect your real estate capital.
1031 Exchange
If the asset you’re selling falls under the real estate category, a 1031 exchange can help you reduce, and potentially even eliminate, the capital gains tax. However, you must follow specific rules to take advantage of this tax code.
- First, the property you’re selling can only be an investment or business property. You cannot perform a 1031 exchange on a primary residence or vacation home.
- To qualify for 100% tax deferment, the market value of the property you’re purchasing must be of equal or greater value than the property you’re selling.
- The property you’re selling and the property you’re buying must be of “like-kind”. As defined by the IRS, a like-kind property must be “of the same nature or character, even if they differ in grade or quality”. This doesn’t mean you have to exchange an apartment building for an apartment building, but rather an investment property for an investment property.
- Both the property being sold and the property being bought must be purchased by the same party.
- From the day you sell the property, you have 45 days to choose 3 potential replacement properties.
- You must complete the exchange within 180 days of selling the property.
There are more rules to 1031 exchanges than we can list here. Be sure to speak with a trusted financial advisor before attempting to make a 1031 exchange.
As a real estate owner, you can continue to defer tax as long as you keep doing 1031 exchanges. For example, you can sell a condo and purchase a duplex, then sell that and purchase an apartment building, then sell that and purchase a commercial building, etc. As long as you follow the above rules.
If you pass away, your beneficiaries get a step up in cost basis. This essentially permanently eliminates the tax.
Delaware Statutory Trust (DST)
A Delaware Statutory Trust can be a great solution for real estate owners that no longer want to manage their properties. A DST is a type of business trust where the trustee is a professional management company. The trust holds a piece of property and allows investors to pull their capital so they can acquire properties they otherwise couldn’t afford. Because DSTs are professionally managed, it effectively makes them a passive income tool.
Another benefit of a Delaware Statutory Trust is the ability to diversify. With a DST, you can own a small piece of many different properties. This limits your risk because if one property tanks, the others may not be impacted.
Investing in a DST can help you avoid capital gains tax.
Installment Sale Method
If you’re selling real estate property in 2022, you’re likely selling for a large profit. However, you’re also setting yourself up for a huge capital gains tax. An installment sale can help lessen the tax burden while the real estate market cools off.
The installment sale method utilizes a third party, called a qualified intermediary, to whom you sell your assets. Then, they pay you installments over a certain period. Because the large profit never directly hits your bank account, you won’t have as big of a tax burden.
How to Defer Capital Gains Tax on Businesses and Other Assets
Many investors who have held stocks or business interests for a long period are sitting on a tax time bomb. There are several strategies you can use to defer, discount, and avoid capital gains tax on these assets.
Qualified Opportunity Zone Fund
Qualified opportunity zones were created in 2017 under the Tax Cuts and Jobs Act. They are meant to encourage investment in areas that the state has targeted for economic redevelopment.
Qualified opportunity zones provide(d) three major tax benefits:
- Deferral of capital gains tax: You can defer paying capital gains tax on the sale of an asset if you reinvest the proceeds into a qualified opportunity zone fund within 180 days. Under current law, tax is deferred until 2026. However, there is current legislation being pushed through Congress to extend this deferral to 2028.
- Step up in cost basis: Unfortunately, this benefit was sunsetted at the end of 2021. However, there is current legislation being pushed through Congress to reinstate this benefit. Under the step up in cost basis, if you were in an opportunity zone fund for five years you got a 10% step up. If you were in it for seven years, you received a 15% step up.
- Flexibility: The actual investments made within these opportunity zones are typically real estate developments, but they can also be new companies.
If you feel like you’re stuck in a capital gains problem, all hope is not lost! You can greatly reduce your tax burden by working with a qualified financial advisor. The professionals at DuPont Wealth Solutions are ready to discuss your goals and help transform your financial future. Call 614-408-0004 today to schedule a free assessment.