As mentioned before, one of the biggest ways that individuals can incur capital gains tax is when they sell their homes. This article will go into more detail about some strategies for avoiding this in your future home sale!
This includes both selling your current house and buying new property. While it may be difficult now, you can save large amounts of money in the long run by investing in real estate.
Many people make big profits off the sale of their houses, but unfortunately, they also pay high taxes on all of that profit. It is important to be aware of potential loopholes so that you don’t have to fork over too much cash.
There are several strategies that sellers use to avoid paying as many taxes as possible, which is good for them, but not ideal if you want to get the best deal on your house. These include things like depreciation or income deduction, using the children as tenants, and even choosing to live closer to work instead of owning your own home.
Luckily, there are alternatives to these if you are determined to invest in real estate. The most common ones are the cost-basis method and the net-realization method.
The cost-basis method means calculating what you paid for your house less any costs related to it (such as mortgage payments) and then comparing that to its market value at the time of sale. The difference is how much capital gain you owe in income and/or inheritance tax.
Know your neighbors
As we mentioned before, one of the biggest ways to reduce or even eliminate capital gains tax is by owning multiple properties. The less income you have, the more likely it is that you will be able to claim losses from one investment property and use those losses to offset any potential capital gain on another investment property.
If you’re in a position to do this, then you can save lots of money on tax!
But before investing in additional real estate, make sure you are familiar with how much capital gains tax you may incur.
We’ve gathered some information and tips here for you to consider.
Hold your property as a tenant
As we have seen, if you are in possession of real estate (renting it or owning it) then ensuring that you pay enough rent is important for avoiding capital gains tax.
However, one other way to avoid paying capital gain tax is to be a ‘tenant’ rather than a ‘owner-occupier’ of the property. This means that you do not live at the property, instead renting from the owner who lives there.
By being a tenant, you will also not face inheritance tax either because tenants are excluded from inheriting the house they reside in.
Invest through a partnership
As we mentioned earlier, individuals are not necessarily taxed when they sell their homes. However, when they do choose to liquidate their home, they may be liable for capital gains tax. This can get expensive very quickly!
Fortunately, there is an easy way to avoid this risk. By investing in real estate as part of a business or partnership, you can potentially reduce your individual taxes significantly.
A limited liability company (LLC) is commonly considered to be the best structure for such investments. An LLC allows each member to limit his or her personal exposure to loss to zero.
This makes it possible to own a much higher quality property than if you were buying directly from the seller, without risking too much money.
By doing so, you also reduce your overall taxable income.
As with any investment, there will still likely be some additional costs involved. These include accounting fees, legal expenses, and potential transaction costs like brokers’ commissions. But by going through an established firm, these should mostly be covered by the LLC.
How to invest in real estate through an LLP
There are several different ways to set up an LLP for investing in real estate. Each has its pros and cons, so feel free to compare them before making your choice.
Invest through a LLC
If you are in the investing business, then you will want to make sure that you understand how capital gains tax works. This article will go into more detail about this!
Capital gain means an increase in the price of something due to its sale. For example, if I bought a house for $100,000 two years ago and it sold for $150,000 today, my capital gain would be $50,000 or 50% higher than my purchase.
The reason why this is important is because of how taxes are calculated. The IRS uses the sales price as a starting point to calculate your income tax. Then they subtract any depreciation (the loss of value caused by renovations) and add any other costs like mortgage interest and homeowner’s insurance.
After these calculations, they determine what proportion of the remaining money is considered taxable income. Most people pay around 20-25% in taxes, but very wealthy individuals can face much greater proportions.
This isn’t fair for anyone who invests their hard earned money in property, and it creates an incentive for investors to keep the money they made from selling high. Luckily, there are ways to avoid paying significant capital gains tax when you sell.
One of the most common strategies is to invest via a limited liability company (LLC). An LLC doesn’t have a shareholder, so only personal assets are at risk if the business fails.
Invest through a corporation
As we have discussed, owning real estate as an individual can be expensive and cumbersome at times. If you do not live in one of the top 20 wealthiest cities in America, investing in real estate can be very difficult as most people are surrounded by their lives and therefore cannot easily travel or spend money outside of home.
For individuals that are looking to invest in real estate but do not want to go all-in on it, there is another option. You can create your own business and invest in either rental or sale properties!
This article will talk about some easy ways to avoid capital gains tax when investing in real estate via corporations.
Taxation is always changing, making it hard to get exact numbers for how much capital gain tax applies to certain investments. What we can tell you though, is that the higher the property value, the more likely you will pay extra taxes.
Here are some tips on how to minimize this cost for best practices.
Invest through a trust
When investing in real estate, there is always a risk that your investment will lose value or even go bankrupt. Because of this, most tax laws require you to recognize what is called a capital gain when you sell an asset. A capital gain occurs when you make a profit from selling an asset, typically a property.
A capital gains tax (CGT) applies when you realize profits from owning an asset longer than one year. The CGT only applies if your total income exceeds $50,000 for individuals or $100,000 for couples. If this is the case, then you must pay taxes on any capital gains.
There are several ways to avoid paying CGT on real estate including setting up a limited liability company (LLC), investing through a charitable organization, or putting your money into a qualified residential rental property. All three of these strategies can be done as individual accounts, which means you cannot use the account funds for other purposes.
Invest through an S-corp
There is no good reason to use your personal residence as an investment property, aside from not paying capital gains tax. This will only make your taxes higher!
If you’re in the 28% bracket, investing in real estate could easily cost you hundreds of thousands or even millions in additional taxes. And that’s before you factor in state income tax!
Fortunately, there are ways to avoid this costly trap. One of the most effective strategies is to invest via an S-Corp.
What is an S-Corporation?
An S-corporation is incorporated under the same laws as individual corporations. The main difference is that it can have more limited liability.
This means that instead of each owner being personally liable for all debts, they are only liable up to their percentage share of the business. The other owners bear the rest!
In addition to limiting how much risk each shareholder takes, this also gives shareholders greater access to debt. Many banks will lend money to individuals with little or no proof of credit but not to businesses due to this limitation on liability.
By using an S-Corp, you remove this liability and thus reduce the amount of financing available to you.
Invest through a family member
The easiest way to avoid capital gains tax is to invest directly in real estate owned (REO) by your or a family member’s name. This can include buying a house you live in, renting an apartment, or investing in commercial property.
By adding this investment to your income stream, then it no longer counts as “profit”, making it harder to acknowledge the capital gain.
This also works if your partner/spouse owns a rental home that they will eventually give up, but you want to keep for yourself. You could purchase that home using their ID, and even have them sign off on how much rent you pay so there are no liabilities involved.
We’ve seen some pretty creative ways people have paid for a home without having too many debts attached to it. It’s not possible to know what questions the IRS might ask about any given transaction, but overall, more complex transactions make it less likely we’ll see someone get caught.