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They say death and taxes are inevitable. I’m not so sure, at least when it comes to taxes on your real estate investments.
As a passive real estate investor and former active investor, I’ve done everything from house hacking to flipping to rental properties to real estate syndications and beyond. Real estate comes with plenty of baked-in tax deduction advantages, but with a little forethought, you can avoid taxes on real estate investments altogether.
And if you lose less money to taxes, you can reach financial freedom faster.
Explore the following real estate tax strategies to avoid the tax man when he cometh.
You’ve probably heard of 1031 exchanges: You use the proceeds from selling one property to buy another, and defer paying taxes on your profits. When you sell the new property, you still owe taxes — unless you do another 1031 exchange.
They work well to kick the can down the road, into the indefinite future, but they come with their share of rules and inconveniences.
First, you have to identify a new property within 45 days of selling the old one. To add a little flexibility, you can identify up to three potential properties. You must then settle on one of them within 180 days of selling the old property.
Oh, and you can’t touch the cash proceeds from the sale, either. You need to hire a qualified intermediary to hold your funds for you.
The bottom line: The strategy works well for seasoned pros, but comes with more hassles than casual investors often want.
The ‘lazy 1031 exchange’
Of course, rental properties in general come with more headaches than I want nowadays. So today my real estate investment strategy has evolved to passive investments only.
When I invest in passive real estate syndications, I get a huge depreciation write-off in the first few years of ownership. I show a loss on my taxes, even though I collected cash flow.
Eventually, the property sells, however, and the IRS hits me with capital gains tax and depreciation recapture. Unless I reinvest the money in a new passive real estate deal, that is.
In that case, the depreciation write-off from the new investment cancels out the taxes from selling. So I keep collecting cash flow and profits from appreciation but never owe any taxes on either as long as I keep reinvesting.
Best of all, I don’t have to mess around with qualified intermediaries or strict timelines. I just have to reinvest funds within the same calendar year as the old property sold.
Roth self-directed IRAs
When you invest through a Roth IRA (or other Roth tax-sheltered accounts), the investment grows and compounds tax-free. You pay no taxes when you withdraw funds in retirement.
Unbeknownst to many investors, you aren’t limited to stocks and bonds, to a brokerage IRA account. You can open a self-directed IRA (SDIRA), and invest in virtually anything you want — including real estate. That includes real estate syndications, passive funds, rental properties and other real estate investments.
This strategy really hits warp speed when you invest for “infinite returns.” Investors pursue infinite returns on real estate using leverage: by refinancing an investment and pulling all of their initial capital back out. In active investing, they call this the BRRRR method — short for buy, renovate, rent, refinance, repeat. You keep recycling the same down payment over and over again, adding new properties as each cash flow and appreciate over time.
Some passive real estate syndications apply the same principle, refinancing after renovating and raising rents. You get your investment money back, even though you keep your ownership interest in the property. That means you can keep reinvesting it again and again, continuing to add more passive income.
And you don’t pay a dime in taxes on any of it if you invest through your SDIRA.
Read up on other ways to invest in real estate through tax-sheltered accounts for more ideas.
Pull out equity by borrowing, not selling
Who says you have to sell a property to cash out profits?
Imagine you take out a 15-year mortgage on a rental property. Your renters cover the mortgage payment, and it cash flows a little. As happens in life, 15 years fly by in a blink, and you find yourself with a free-and-clear property worth twice what you paid for it.
You could sell it of course, walk away with a tidy profit. But you’d kill the golden goose, saying goodbye to the cash flow, appreciation and tax benefits.
And you’d owe 15 percent to 20 percent capital gains taxes on it, not to mention another 6 percent to 8 percent in closing costs.
Instead, imagine you take out a fresh mortgage on the property, pulling out 80 percent of its value. That leaves you with more cash in hand than selling, not less, and you avoid mortgage insurance.
You pocket the equity, continue collecting cash flow and tax deductions. In another 15 years, you do it all over again. And when you eventually kick the bucket, your children inherit an investment property that they can either keep or sell — with a reset cost basis.
In other words, no one ever pays capital gains taxes on the property.
As much as I love the tax benefits and high returns on real estate, I also love diversification and invest in a broad range of stock funds.
Say I sell a property one year and end up with a taxable gain of $30,000. If the stock market is having a bad year, and an index fund of mine is down $30,000 in value, I can harvest tax losses by selling the shares.
If I stopped there, I would have just taken a real loss. But the same day I sell those shares, I use the money to rebuy shares in a similar fund. At the end of that day, my stock portfolio looks nearly identical, but I’ve realized a $30,000 loss for tax purposes.
A loss that offsets my $30,000 gain from selling an investment property.
And hey, no one says you have to rebuy shares in a similar fund. Maybe it’s a good time to adjust your portfolio anyway, ditching some losers to invest in funds you’re more confident in.
Live in the property for 2 years
The IRS offers an exemption for capital gains from your primary residence.
Known as the Section 121 exclusion, single filers are exempt from paying capital gains taxes on the first $250,000 of profits on their primary residence. Married couples filing jointly avoid taxes on the first $500,000 of gains.
To qualify, you must have lived in the home as your primary residence for at least two of the last five years. Those 730 days don’t have to be consecutive — you can live in the property for 15 months, move out, then move back in for another nine months to qualify.
That means you could theoretically do a live-in flip, moving into the property with homeowner financing and renovating it slowly over the next two years, then selling for a tax-free profit of up to $250,000 ($500,000 if you’re married). Or you could move out and keep it as a rental for up to three years before selling tax-free.
Combine the standard deduction with itemized expenses
If you actively buy properties, you may be able to deduct for a home office, travel, meals and entertainment as business expenses — on a separate schedule of your tax return from your personal deductions.
That means you could take the standard deduction and still deduct for these.
Get creative to save on taxes
You can mix and match the ideas above, or otherwise get creative in how you use them.
For instance, you could move into one of your rental properties for two years before selling tax-free. You can use the depreciation from real estate syndications to offset dividend income from your stocks. You can convert funds from your traditional IRA to a Roth SDIRA in a year when you’re taking losses elsewhere, to offset the taxable conversion.
Remember, you can carry your passive losses forward as well. So if you take more on-paper losses one year than you need to offset passive income or gains, don’t fret. They carry forward to the following year.
To win a game, you need to know the rules. While IRS rules get complicated quickly, you don’t need to memorize the tax code. You just need to understand a few basic real estate tax advantages — and then maximize them.
G. Brian Davis is a real estate geek and co-founder of SparkRental.