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Capital Gains Tax: Think Creatively When Selling an Investment Property!

By: F5 Financial

Today we dive into investment properties—and demystify the 1031 exchange, which can protect you from huge capital-gains tax bills!

What Commonly Happens When We Acquire a Second Home

It is not uncommon for folks to acquire a second home and rent it out as an investment— or to keep the house they had previously lived in (and rent it) when they buy a new home.

In the last several years, real estate has been a solid investment option and diversification away from traditional equities and bond markets.

If you have owned a rental property in a booming real estate market like Idaho or Florida, you may well be aware that property values have rapidly outpaced many other investment opportunities. That is the good news if you decide to sell. The bad news is that the government wants to be your partner in the sharing of profits in the form of capital gains tax, which is typically 15% or 20% of the profit.

How is Capital Gains Tax Calculated?

When calculating capital gains tax in this scenario, profit is defined as the proceeds minus the cost basis of your property. The cost basis includes the original price you paid for the property, plus any capital improvements like the addition of a new garage or a new roof, as well as the costs of selling the property (agent fees and closing costs). Keeping records of the improvements you make to a property is important to demonstrate the added cost basis!

A Case Study – How a 1031 Exchange Can Eliminate $130,000 in Capital Gains Tax

  • Let’s say you purchased a luxury waterfront condo in North Idaho for $300,000 ten years ago and rented it out. With the booming market, it’s now worth $850,000!
  • After selling it and accounting for the cost of the sale, you have a net Profit of $500,000, sounds great, right?
  • Well, let’s say you and your spouse earned $160,000 in the year you sell, you could be saddled with a Tax bill that includes a 20% Federal capital gains tax, a 6.5% State Capital Gains Tax (not all states have this, so it is important to check), and a 3.8% Net Investment Income Tax all piled on top of each other, for a tax hit of almost $130,000! All of the sudden the luster of that profit has taken a big hit.
  • The good news is, if you decide to use the proceeds of your sale to purchase a “like kind” investment property, you can defer and possibly avoid the Capital Gains Tax altogether with a 1031 exchange!

You can defer and possibly avoid the Capital Gains Tax altogether with a 1031 exchange!

There are strict rules when executing a 1031 exchange, and here we break these down for you:

A 1031 Exchange Requires a Qualified Intermediary

  • A 1031 Exchange Requires a Qualified IntermediaryYou must use a qualified intermediary to receive the proceeds of the sale of your property and to purchase the new property or properties on your behalf. There are firms that specialize in this and finding a reputable one is important. A real estate agent experienced in 1031 exchanges can usually refer you to a good company that executes the exchange, does the paperwork, and knows the regulations. If you personally take possession of the sales proceeds, the 1031 exchange is void!

You must use a qualified intermediary to receive the proceeds of the sale of your property . . . If you personally take possession of the sales proceeds, the 1031 exchange is void!

How to Purchase a “Like-Kind” Property

  • You must purchase a “like-kind” property, meaning exchanging one investment real estate property for another. You cannot use your sale proceeds of real (real estate) property to purchase “personal property” like a boat, even if you were going to rent the boat as a business venture.
  • The like-kind property must be of equal or greater value than the property you sold, if not, the difference is “taxable boot,” meaning any leftover funds after the exchange will be subject to capital gains tax.
  • The Clock is ticking when you sell your property, and the proceeds are transferred to the qualified intermediary. You have 45 days to identify up to three properties you wish to purchase, and 180 days to close the sale. You must notify in writing the properties to the qualified intermediary. This can be a bonus to a buyer, as many times this ends up as a cash offer, and the seller knows they are very serious buyers due to the time constraints!

There are wrinkles to these main concepts that are beyond the scope of this article, but these are the basics.

A Financial Advisor Can Help You Navigate Tax Complexities with Success—Including Capital Gains Taxes!3 Possible Outcomes for Our Case Study

Let’s say our couple sold their North Idaho condo and purchased a vacation rental home in Venice, Florida (the location of one of the F5 offices, as it happens).

Option 1: Rent the New Property, and Vacation There 14 Days Per Year

They may be able to rent this home for more money as a short-term vacation rental—and use 14 days out of the year to enjoy Florida's tourist offerings, like a trip to Disney World with the kids or exploring the beaches Venice has to offer (because they can use the property for up to 14 days a year and still maintain its status to the IRS as an investment property).

Option 2: Keep the New Property for 5 years, Become Residents, and then Enjoy a $500,000 Capital Gains Exclusion When Selling

After renting the house for 2-3 years, the couple may plan to retire and move to Florida and live in the house for 2 years, and after holding the property for 5 years could take advantage of the $500,000 capital gains exclusion because it would now qualify as their primary residence, greatly reducing the tax bill if they decided to sell it.

Option 3: Hold the Property in Your Estate

They could also hold the property in their estate, and the step-up in basis would mean the house cost basis would be reset, meaning capital gains would only be taxable after the transfer of the estate for increases on this reset cost basis.

A Financial Advisor Can Help You Navigate Capital Gains Tax Complexities with Success

Huge capital gains tax bills can be a frustrating part of a real estate transaction of an investment property, but with a little creative thinking, they can be deferred and even avoided if certain conditions are met. Tax planning can be tricky, and having an experienced fee-only financial advisor help you navigate the ins and outs of maximizing your income from financial transactions can be hugely beneficial. For more information on how we can help you, please schedule a free consultation.

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  • Do you have a well-defined Investment Policy Strategy that is used to drive your investments in support of a comprehensive financial plan?

  • If not, would you like to partner with someone who is used to helping people get through these struggles and (then, with confidence) implement portfolio strategies in a systematic manner while focusing on your desired outcomes?

If so, feel free to send us an email or give us a call. We’d love to have the opportunity to help you find a bit more peace of mind when it comes to investing.


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F5 Financial

F5 Financial is a fee-only wealth management firm with a holistic approach to financial planning, personal goals, and behavioral change. Through our F5 Process, we provide insight and tailored strategies that inspire and equip our clients to enjoy a life of significance and financial freedom.

F5 Financial provides fee-only financial planning services to Naperville, Plainfield, Bolingbrook, Aurora, Oswego, Geneva, St. Charles, Wheaton, Glen Ellyn, Lisle, Chicago and the surrounding communities; to McDonough, Henry County, Fayette County, Atlanta and the surrounding communities; to Venice, Sarasota, Fort Myers, Port Charlotte, Cape Coral, Osprey, North Port, and the surrounding communities; and nationally.

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