The single greatest predictor of wealth in the U.S. isn’t education level, ethnicity, gender, or any other demographic descriptor. It’s whether or not you own real estate.
In the most recent Survey of Consumer Finances, the Federal Reserve found the median net worth of homeowners to be 46 times greater than that of renters. While the median renter had a net worth of $5,000, the median homeowner owned $231,400 in net assets.
Homeowners benefit from appreciation, forced savings in the form of principal repayment toward mortgages, and often lower annual housing costs compared to local renters. Those advantages get compounded by a tax code that favors property owners. Beyond simple homeownership, real estate investors can reduce their taxes through myriad strategies and incentives.
Still, when it comes time to sell, many property owners face sticker shock at their prospective tax bill. So how can property owners reduce — or better yet, eliminate — their taxes when they go to sell?
Common Real Estate Exit Strategies
Try these low- and no-tax real estate exit strategies to keep more of your real estate profits in your pocket and out of Uncle Sam’s grasping paws.
1. The Homeowner Exclusion
To begin, homeowners get an inherent tax break when they sell their home — with certain requirements and restrictions, of course. If you’re a homeowner selling your primary residence, chances are you won’t have to pay taxes on your profits from the appreciation of the home’s value since you bought it.
Single homeowners can exclude the first $250,000 in profits from their taxable income, and the number doubles for married couples filing jointly. Sometimes called a Section 121 Exclusion, it prevents most middle-class Americans from having to pay any taxes on home sale profits.
Any profits over $250,000 ($500,000 for married couples) get taxed at the long-term capital gains tax rate. More on that shortly.
To qualify for the exclusion, however, homeowners must have owned and lived in the property for at least two out of the last five years. They don’t have to be consecutive; if you lived in the property for one year, moved out for three years, then moved back in for one more year before selling, you qualify.
If you want to sell a property you don’t currently occupy as your primary residence, and want to avoid taxes through a Section 121 Exclusion, consider moving into it for the next two years before selling.
2. Opt for Long-Term Capital Gains Over Short-Term
If you own a property — or any asset for that matter — for less than a year and sell it for a profit, you typically pay short-term capital gains tax. Short-term capital gains mirror your regular income tax level.
However, if you keep an asset for at least one year before selling, you qualify for the lower long-term capital gains tax rate. In tax year 2020, single filers with an adjusted gross income (AGI) under $40,000 pay no long-term capital gains taxes at all — the same goes for married filers with an AGI under $80,000. Single filers with incomes between $40,001 and $441,450 and married filers between $80,001 and $496,600 pay long-term capital gains at a 15% tax rate, and high earners above those thresholds pay 20%.
Keep your investment properties and vacation rentals for at least one year if you can. It can save you substantial money on taxes.
3. Increase Your Cost Basis by Documenting Improvements
If you slept through Accounting 101 in college, your cost basis is what you spent to buy an asset. For example, if you buy a property for $100,000, that makes up your cost basis, plus most of your closing costs count toward it as well. Let’s call it $105,000.
Say you live in the property for 20 months, making some home improvements while there. For the sake of this example, say you spent $15,000 on new windows and a new roof.
Then you sell the property for $160,000. Because you lived there for less than two years, you don’t qualify for the homeowner exclusion. After paying your real estate agent and other seller closing costs, you walk away from the table with $150,000.
How much do you own in capital gains taxes?
Assuming you earn enough income to have to pay them at all, you would owe the IRS for $30,000 in capital gains: $150,000 minus your $105,000 cost basis minus the additional $15,000 in capital improvements. If you can document those improvements, that is — you need to keep your receipts and invoices in case you get audited.
In this example, your capital gains tax bill would come to $4,500 (15% of $30,000) if you document the capital improvements, rather than $6,750 (15% of $45,000) if you don’t.
4. Do a 1031 Exchange
Section 1031 of the U.S. tax code allows investors to roll their profits from the sale of one property into buying a new property, deferring their capital gains tax until they sell the new property.
Known as a “like-kind exchange” or 1031 exchange, you used to be able to do this with assets other than real estate, but the Tax Cuts and Jobs Act of 2017 excluded most other assets. However, it remains an excellent way to avoid capital gains taxes on real estate — or at least to postpone them.
Real estate investors typically use 1031 exchanges to leapfrog properties, stocking their portfolio with ever-larger properties with better cash flow. All without ever paying capital gains taxes when they sell in order to trade up.
Imagine you buy your first rental property for $100,000. After expenses, you earn around $100 per month in cash flow, which is nice but you certainly won’t be retiring early on it.
You then spend the next year or two saving up more money to invest with, and set your sights on a three-unit rental property that costs $200,000. To raise money for the down payment, you sell your previous rental property, and net $20,000 in profit at settlement. Ordinarily you’d have to pay capital gains taxes on that $20,000, but because you put it toward a new rental property, you defer owing them.
Instead of $100 per month, you net $500 per month on the new property.
After another year or two of saving, you find a six-unit property for $400,000. You then sell your three-unit to raise money for it, and again use a 1031 exchange to roll your profits into the new six-unit property, again deferring your tax bill on the proceeds.
The new property yields you $1,000 per month in cash flow.
In this way, you can keep scaling your real estate portfolio to build ever-more cash flow, all the while deferring your capital gains taxes from the properties you sell. If you ever sell off these properties without a 1031 exchange, you will owe capital gains tax on the profits you’ve deferred along the way. But until then, you need not pay Uncle Sam a cent in capital gains.
5. Harvest Losses
Invest in enough assets, and you’ll end up with some poor performers. You can sit on them, hoping they’ll turn around. Or you can sell them, eat the loss, and reinvest the money elsewhere for higher returns.
It turns out that there’s a particularly good time to accept investment losses: in the same year when you sell a property for hefty capital gains. Known as harvesting losses, you can offset your gains from one asset by taking losses on another.
Say you sell a rental property and earn a tidy profit of $50,000. Slightly nauseated by the notion of paying capital gains tax on it, you turn to your stock portfolio and decide you’ve had enough of a few stocks or mutual funds that have been underperforming for years now. You sell them for a net loss of $10,000, and reinvest the money in (hopefully) better performing assets.
Instead of owing capital gains taxes on $50,000, you now owe it on $40,000, because you offset your gain with the losses realized elsewhere in your portfolio.
6. Invest Through a Self-Directed Roth IRA
Want more control over your IRA investments? You can always set up a self-directed IRA, through which you can invest in real estate if you like.
Like any other IRA, you can open it as a Roth IRA account, meaning you put in post-tax money and don’t owe taxes on returns. Your investments — in this case, a real estate portfolio — appreciate and generate rental income tax-free, which you can keep reinvesting in your self-directed Roth IRA until you reach age 59 1/2. After that, you can start pulling out rent checks and selling properties, all without owing taxes on your profits.
Just beware that setting up a self-directed IRA does involve some labor and expense on your part. I only recommend it for professional real estate investors with the experience to earn stronger returns on real estate investments than elsewhere.
Pro tip: In addition to owning physical properties through a self-directed IRA, you can also use your self-directed IRA to invest in real estate through platforms like Fundrise or Groundfloor.
Hold Properties to Pass to Your Children
“Exit strategy” doesn’t always mean “sell.” The exit could happen in the form of your estate plan.
Or, for that matter, through methods of passing ownership of properties to your children while you still draw breath. There are several ways to go about this, but consider the following options as the simplest.
7. Leave the Property in Your Will
In 2020, the first $11.58 million in assets you leave behind are exempt from estate taxes. That leaves plenty of room for you to leave real estate to your children without them getting hit with a tax bill from Uncle Sam.
And, hey, rental properties can prove an excellent source of passive income for retirement. They generate ongoing income with no sale of assets required, which means you don’t have to worry about safe withdrawal rates or sequence of returns risk with your rental properties. They also adjust for inflation, as you raise rents each year. You can delegate the labor by hiring a property manager, and once your tenants eventually pay off your mortgage, your cash flow really explodes.
Plus, you can let your kids hassle with hiring a real estate agent and selling the property after you depart this mortal plane. In the meantime, you get to enjoy the cash flow.
8. Take Out a Home Equity Loan
Imagine you buy a rental property while working, and in retirement, you finally pay off the mortgage. You can enjoy the higher cash flow of course, but you can also pull money out through a home equity loan.
In this way, you pull out almost as much money as you’d earn by selling. Except you don’t have to give up the property — you can keep earning cash flow on it as a rental. You let your tenants pay down your mortgage for you once, all while earning some cash flow. Why not let them do it a second time?
You pull out all the equity, you get to keep the asset, and you don’t owe any capital gains taxes. Win, win, win.
You can follow the same strategy with your primary residence, but in that case you incur more personal debt and living expenses. Not ideal, but you have another option when it comes to your home.
9. Take Out a Reverse Mortgage
Along similar lines, you could take out a reverse mortgage on your primary residence if you have equity you want to tap into. These vary in structure, but they either pay you a lump sum now, or ongoing monthly payments, or a combination of both, all without requiring monthly payments from you. The mortgage provider gets their money back when you sell or kick the bucket, whichever comes first.
For retirees, a reverse mortgage helps them avoid higher living expenses while pulling out home equity as an extra source of income. And, of course, you don’t pay capital gains taxes on the property, because you don’t sell it.
10. Refinance & Add Your Child to the Deed
My business partner recently went to sell a rental property to her son for him to move into with his new wife. But the plan derailed when the mortgage lender declined the son’s loan application.
So they took a more creative approach. My business partner and her husband refinanced the property to pull out as much cash as they could, and they had the title company add their son and his wife to the deed and the mortgage note. The son and daughter-in-law moved into the property, taking over the mortgage payments. My partner and her husband took the cash, and while they remain on the deed, their ownership interest will pass to the younger generation upon their death.
In this way, they also streamline the inheritance, as the property won’t need to pass through probate.
This strategy comes with two downsides for my partner and her husband, however. First, they remain liable for the mortgage — if their son defaults, they remain legally obligated to make payments. Second, mortgage lenders don’t lend the entire value of the property when they issue a refinance loan, so my partner didn’t receive as much cash as she might have if she’d sold the property retail.
Of course, she also didn’t have to pay a real estate agent to market it. And any small shortfall in cash from refinancing rather than selling outright could be collected as a “down payment” from your child, or you could just shrug and think of it as a gift.
Other Exit Strategies
11. Donate the Property to Charity
Finally, you can always avoid taxes by giving the property to your charity of choice.
No clever maneuvers or tax loopholes. Just an act of generosity to help those who need the money more than you or Uncle Sam do.
By donating real estate you not only avoid paying taxes on its gains, you also get to deduct the value — in this case the equity — from your tax return. But bear in mind that the IRS looks closely at charitable deductions, especially house-sized ones, and you may hear from them demanding more information.
Property owners have plenty of exit strategies at their disposal to minimize capital gains taxes. But don’t assume all of these options will last forever — with an ever-widening federal budget deficit, expect tax rates to rise and investment-friendly tax rules to suffer. Your taxes may go up in retirement, not down.
Whether you own a real estate empire or simply your own home, choose the strategy that fits your needs best, and aim to keep more of your proceeds in your own pocket.
What are your exit strategies for your properties? How do you plan to minimize your tax burden?