If you’re a real estate investor, you’re likely familiar with capital gains tax and how it can significantly affect your profit. Understanding capital gains and when the taxation occurs can help you make more informed decisions about your investment properties.
You may wonder how some people end up with a tax bill that is larger than the amount of cash they take home from the sale of their property. Or maybe, this has happened to you and you don’t know how you got here. Let’s take a moment to explain how this is possible so that you don’t find yourself in this unfortunate circumstance.
Additionally, we’ll show you how a 1031 exchange can be a solution that may save you from having to withdraw from your 401K to pay your taxes.
So how does someone end up here? We all know that capital gains taxes will be owed on any profit made from the sale of a property. For a more complete explanation on how capital gains taxes are calculated read our explanation here.
What Are Capital Gains?
- The amount the property is sold for,
- The amount of cash you put in your pocket after the sale,
- The difference between the appraisal amount and the sale amount,
- The amount remaining after loans are paid off, or
- The difference between the purchase price and the sale price.
Capital gains are profits you receive when selling an asset. Just as the Internal Revenue Service (IRS) taxes income, it also taxes capital gains. You earn capital gains when you sell an asset for a higher price than its basis.
Gains fall into two categories — unrealized and realized. Unrealized gain is potential profit on paper. If an asset you purchased for $20,000 is now worth $25,000, you have $5,000 in unrealized gain. You have realized gain when you sell that asset and officially earn that $5,000 in profit.
Capital gains can stem from various asset types, such as stocks, precious metals, bonds, and real estate property. In the case of real estate, capital gains are any closing costs, upgrades, depreciation, and the initial purchase amount subtracted from the sale price. The tax rates for your capital gains will vary based on how long you own the property.
Depending on the short-term or long-term nature of your investment in the property and whether or not self employment taxes will factor in, you could be taxed as low as 15% on your capital gains or as high as 40%.
The time that you owned the property is not the only factor that determines whether you will be taxed at long-term or short-term rates. Therefore, it is vital that you work with a tax consultant prior to buying a property and at the time of selling to determine how much capital gains taxes will affect your real estate investment.
You may be thinking that even if an investor does owe 40% of their capital gains to the IRS, they still have 60% of the gains to deposit into the bank, right? Not always.
How Can You Owe More in Taxes Than What You Received in a Sale?
Depending on the size of your profit and the capital gains tax enacted on your profit, you may pay more in taxes than what you receive on the sale. High capital gains taxes typically arise from short-term ownership. When you own a property for less than a year, then sell the asset, your profit is short-term capital gains.
Short-term capital gains are different from assets sold after a year of ownership because the IRS treats them as part of your annual income. For example, if your taxable income for the year is $85,000 and you receive short-term capital gains for $20,000, your taxable income becomes $105,000.
This new amount moves you to the next tax bracket. In 2021, this tax bracket percentage was 24%, so you’d have to pay $25,200 in taxes — $5,200 more than your original profit. Long-term capital gains — assets sold after a year or more of ownership — have their own tax thresholds separate from income tax.
How to Avoid Capital Gains Tax
Completing a 1031 exchange with your property can help you defer capital gains tax at the time of the exchange. To successfully complete one of these exchanges, you must abide by a series of rules. Some of these rules include:
- You must work with a qualified intermediary to complete the exchange.
- You must identify an exchange property within 45 days of selling your asset.
- The new property must be of equal or greater value than the asset you sold.
- The relinquished property and new property must be like-kind.
- You must close the sale in 180 days following identification.
If you follow the requirements for a 1031 exchange, you can enjoy the advantages of deferred capital gains tax.
Defer Capital Gains Tax at 1031 Crowdfunding
When you register at 1031 Crowdfunding, you can access our extensive selection of properties for 1031 exchanges. You can benefit from property listings that are easy to browse, plus gain access to our real estate experts who can help you through the identification and closing periods. We’ve helped many of our clients close on properties within a week. Register at 1031 Crowdfunding today.