How to Sell Real Estate and Pay Little to No Taxes
By Amanda Han, Author of The Book on Tax Strategies for the Savvy Real Estate Investor
Although we can currently utilize the wonderful tool of a 1031 exchange to defer our taxes without any limitations, that may change in the near future. Before we talk about the possible changes, let’s take a quick look at what a 1031 exchange is.
What is a 1031 exchange?
If you are looking to dispose of a rental property and plan on reinvesting the proceeds into another real estate deal, a 1031 exchange can help you to defer the taxes. Simply put, a 1031 exchange is a tax loophole that allows you to sell one property and defer payment of taxes on the gain when you reinvest in another investment property. Some of the main rules for a 1031 exchange include:
- The person or entity selling the relinquished property must be the same person/entity buying the replacement property.
- Once the relinquished property is sold, the replacement property must be identified within 45 calendar days and the purchase must be closed on within 180 calendar days (both dates start from the sale date).
- To receive a full tax-deferral, the replacement property’s purchase price and equity need to equal or exceed those amounts from the relinquished property.
If implemented correctly, a 1031 exchange can help you to not only defer taxes, but may also allow you to wipe out the tax on your real estate gains permanently. This is commonly referred to as the “swap until you drop” strategy.
Potential changes to the 1031 exchange
The President’s 2023 budget currently includes some proposed tax changes to the 1031 exchange benefit. The proposed changes, if passed, could limit 1031 exchanges to an annual maximum deferral of $500,000 per person. This means that if you sold a rental property for a $800,000 taxable gain, a 1031 exchange may only help you defer up to $500k of that gain and the remaining $300,000 could be taxable in the current year.
To be fair, there is no indication that this section in the proposed budget will pass and become law anytime soon. In fact, we are still very far from that happening. But even outside of the potential law change, there are times when a 1031 exchange is not the most ideal solution when it comes to tax deferral. With the hot real estate market, it can sometimes be difficult to identify and close on properties within the timeline and monetary restrictions of a 1031 exchange. In addition, investors may be interested in keeping some of the cash from the sale and not roll all of it into another property. Or if you are no longer interested in being a landlord and prefer to be a passive investor, then a traditional 1031 exchange may not be as appealing to you either.
So, this brings up the question:
Are there alternative ways to offset taxable gain outside of using a 1031 exchange?
If you have a healthy gain built up in your real estate, here are some other strategies that can potentially help you to minimize the tax bite.
Seller-Financing
If you are looking to sell your property to lock in today’s market price, but do not necessarily need the money, then consider doing seller-financing. When you enter into a seller-financing deal, it is an executed sales contract in that your buyer has locked into a purchase price at today’s higher market value. However, on the tax side, you do not necessarily need to pay taxes on the full gain from your sale right now. Instead, in a seller-financed deal, you can defer the taxes on your gain over time each year as you collect your payments. So selling a property with a 10 year note can help you split up and defer your taxes over the next 10 years.
Offset Strategy
Whether you chose not to do a 1031 exchange or if you failed a planned 1031 exchange, another way to reduce your taxes is with offset strategies. Let’s go over an example.
Bob sold his apartment for a $600k tax gain. He had all the right intentions to do a 1031 exchange to defer his taxes, but he was not able to negotiate the deal for the replacement property within the 180-day timeframe. Not wanting to overpay for the property, Bob decided to walk away from that transaction with a large tax bill. The good news is that a few months later, Bob ended up finding another awesome deal in a mobile home park. Bob closed on that investment and did a cost segregation to accelerate his depreciation write-off for the year. The result was that Bob’s new mobile home park investment created a large tax loss for the year. The large taxable gain from the sale of the apartment was reduced significantly from the tax loss created by the new mobile home park investment in the same year.
Going Passive
Buying your own investment property is not the only way to utilize the offset strategy to reduce your taxes when selling a property. This can also be accomplished even if you are someone who no longer wants to be actively involved in your real estate as a landlord. Let’s take Bob’s example above: If instead of buying that mobile home park, Bob decided to become a passive investor into a syndication deal. If the syndication uses a similar strategy and issues Bob a K-1 showing a large tax loss, that loss can also be used to offset some of the tax gain on from Bob’s apartment sale. We have seen this work out well for a lot of investors who want to semi-retire from their active real estate.
Opportunity Zone Investments
Investing in an Opportunity Zone Fund can be a viable alternative to the 1031 exchange. An Opportunity Zone fund investment can help the investor to defer the capital gains taxes from a sale into the 2026 tax year. In addition, if the replacement asset in the opportunity zone is held for at least 10 years, the appreciation of the O-Zone asset may be permanently tax-free. Let’s go over an example. Mary sells a property for $800,000 with a gain of $500,000. She decides to keep $300,000 of the cash for personal use. She later decides, within 180 days from the sale date, to invest $500,000 into an Opportunity Zone Fund. By doing so, Mary can defer the taxes on that $500,000 of gain into the 2026 tax year. If Mary’s $500,000 investment appreciates to a $900,000 asset after 10 years, Mary may be able to avoid paying taxes altogether on that $400,000 appreciation.
Opportunity Zone Funds can be large syndication deals or small funds owned by just two individuals. There are a lot of other rules to meet for Opportunity Zone Funds, so if you feel like this may be a good alternative strategy for you, make sure to speak with your tax advisor for more details.
Keep the Property
Selling isn’t the only way to take money out of your real estate deals. A perfectly good way to do that is to simply refinance and pull the cash out. For example, if you purchased your investment property for $500k with a $100k down payment, but it is now worth $900k, it is possible to refinance and pull out an additional ~$500k of cash with bank financing. This may be a good time to use this strategy in today’s climate because current interest rates are still somewhat reasonable.
If you can do a low-cost refinance, lock in a low 30-year interest rate, and use the loan proceeds to invest in other properties, you may be able to supercharge your wealth building. Another added benefit of keeping the property and refinancing it is that with a refinance, you are pulling out the cash free of taxes. So instead of paying the IRS, you can use 100% of your loan proceeds into your next deal. If the loan proceeds are used for investment real estate, it may be possible to write off the interest on that new loan as well in future years.
When the market is hot, we need to be proactive about what investment decisions we make. Whether it is to cash out, trade up, or buy more, make sure that you work with your team of advisors so that you can make the most well-informed decision to super charge your wealth and keep more of your bottom line.
Planning is Key
As you can see, a 1031 exchange is not the only tool in the toolbox when it comes to deferring taxes. It is extremely important for us as real estate investors to grow our portfolio in a tax efficient manner. When implemented correctly, these strategies may even help to create generational tax-free wealth. As real estate values increase, it can be a great time to look at repositioning some of your assets. Before doing so, be sure to meet with your tax advisor to review your portfolio and plan ahead. Taking the time to plan now can help you keep more of your money rather than paying it to the IRS.
About the Author
Amanda oversees the development and implementation of tax saving strategies for real estate investors and high net worth clients., specializing in retirement planning and investing strategies including self-directed investing. She has numerous years of experience in working with international companies in terms of federal and multistate tax planning and compliance as well as audit representation and resolution. 20+ years of experience in public accounting servicing both publicly traded and closely held companies in the real estate industry. Certified by the CA State Board of Accountancy and a member of the prestigious American Institute of Certified Public Accountants.
Accessibility