Real estate investors are hit much harder than most by capital gains taxes, as they must pay them on any profits from selling real estate held longer than one year.
Capital gains taxes are on long-term profits from investments, such as sales of real estate and stocks, and dividends. “Long-term” is defined by Uncle Sam as being held for at least 366 days; gains from assets owned for less than a year are taxed at the normal income rate, the maximum rate of which rose in 2013 from 35% to 39.6%.
Capital gains tax follows a bracket system, where people earning different amounts of money pay different tax rates on capital gains. The thresholds vary year to year, but on the federal level there is a 0% capital gains bracket for low income earners, a 15% for middle income earners, and a 20% bracket for high income earners. States often impose their own capital gains taxes on top of the federal taxes.
Wait though, it gets more complicated. Real estate holdings in which the owner claimed depreciation (which is pretty much every real estate investor holding property for longer than a year) are partially taxed at a higher capital gains rate. The amount depreciated is subject to a 25% depreciation-recapture capital gains tax rate, then the rest of the proceeds are subject to the normal capital gains tax rate. That’s convoluted enough to warrant an example: when Investor Ivan sells his rental property, which he bought last year and deducted $3,000 depreciation for, he makes a $10,000 profit and pays the 25% tax rate on $3,000 of that profit, and pays his normal capital gains rate (let’s say for him that’s 15%) on the other $7,000.
And recently, the Obamacare tax on capital gains and other net investment income now takes another 3.8% for higher-income earners.
All right enough math, how do I reduce my capital gains tax liability?
Money invested in a traditional IRA is tax-deferred until you take it out years from now when you retire (note: Roth IRAs are the opposite – you pay taxes on it now, but not later when you draw on the money). It can be deducted from your taxable income, and left alone for the next few decades to earn massive returns for you to spend in your golden years. Warning: there are limits on how much the IRS lets you invest tax-free – in 2013 this limit is $5,500 for those under 50, and $6,500 for older adults.
2. Own Your Own Home
There is a special exemption for primary residences, when it comes time to sell: the first $250,000 of profit for singles ($500,000 for married couples) is tax-exempt, and you can deduct any money you put into the property over the years from this profit, so save all those Home Depot receipts and contractor invoices.
3. Tax-Exempt 529 College Savings Accounts
While contributions to 529 college savings accounts are included in your taxable income, the earnings over the years are not. So, no capital gains tax is owed, as long as the earnings are spent on college costs. In some states, contributions may also be tax-deductible, making for a double tax discount.
4. 1031 Exchanges
The simplified explanation is that real estate investors can take their profits from the sale of one property and invest them in a new property purchase, and defer their capital gains taxes until they sell the new property (if ever). See our overview of 1031 exchanges.
5. Charitable Remainder Trusts
These can get a little complicated, but the short version is you can create a trust and donate assets to it tax-free, and then the trust pays you a certain amount each month (or year) for the rest of your life from those assets and their earnings. Upon your death, the balance of the trust’s assets goes to a charity of your choosing.
6. Move to a Tax-Friendlier State
Many states have capital gains taxes on top of the hefty slice that the federal government takes; for example, California takes an additional 13.3%, which for higher-income families means a total capital gains tax rate of 37.1% (never mind all the other types of taxes).
7. Gifts to Family
You can give up to $14,000 in assets to each family member tax-free, every year. If the family member sells the asset, they will owe capital gains on it however (unless of course they are in the 0% capital gains tax bracket).
8. Charitable Donations
An oldie but goodie – instead of throwing your old belongings away, donate them to charities, and deduct their value from your taxable income! Be careful not to deduct too much for this however – the IRS often uses high donations as an audit trigger (bringing to mind the old aphorism that "no good deed goes unpunished").