How to Avoid Paying Capital Gains Tax
Investment in a 1031 Exchange Property
First, let’s look at how the process of purchasing assets works. When you invest in a property, typically, you make a down payment to cover costs. After the down payment, any remaining funds go towards the total cost of the property, including any interest you pay, any repairs, and any improvements that come along after you buy the property. The amount you end up with depends on the property for sale that you are buying, but you will at least have some of what is left over after the purchase process is complete.
One part of the purchase process, then, deals with what is known as replacement property exchanges. A replacement property exchange happens when your original property is sold for less than what you originally paid. In exchange, the government allows you to buy back your property, called a replacement property. The amount of money you receive from the exchange will be determined by a few factors, including the property’s current market value, any outstanding taxes on the property, and the value of the replacement property. This is one of the advantages of dealing with real estate transactions through an agent or professional firm; generally, they will help you obtain the tax advantage you need.
Advantage of the exchange
When you get involved in a replacement property exchange, there are certain rules that you must follow to take full advantage of the exchange. For example, to get the full value of your investment, it will be necessary to have a greater value mortgage. Suppose you don’t own the property you are purchasing and use the mortgage amount to purchase the replacement property. In that case, you will not be able to deduct the interest on the mortgage, which makes the exchange a no-profit situation for you. Because the mortgage is a replacement property and is used as the selling point in the transaction, it will be necessary to attach a capital gain to the mortgage amount.
Make a profit
On the other hand, if you are purchasing several properties to make a profit on each property and there are multiple types of properties, you will be able to deduct interest on those properties. In general, if a person has a capital gain and that gain is due to the sale of several different kinds of property within one year, then that person can deduct that gain on all of the properties they own within that year. If the person owns five or more kinds of property within a single year and owns those properties primarily in the same location, then that person is subject to only one capital gain for that year. However, to take advantage of the 1031 exchange and attach a greater value mortgage to each property you purchase, you will need to purchase properties at greater values.
Capital gains tax
Capital gains tax can be avoided by holding the property for a certain amount of time after purchase. This can be accomplished by holding the property for the entire life of the property. If you purchase property for the life of the property, you will be able to deduct the capital gain immediately. Holding the property for the entire life of the property will give you the largest tax savings. But, if you purchase the property for less than the life of the property, then you will lose out on the benefits. The tax benefits associated with holding onto the property for the full 180 days or until the end of the tax year will be lost.
There are a couple of ways that you can get around this issue. One way is to hold onto the property for the entire 180 days and use a replacement property, such as a vacation property, for the remaining portion of the period of holding onto the property. You will not be able to deduct the capital gain on the replacement property for the months during which you held onto the home. Another way to get around the problem of holding onto the property for 180 days is to use the 1031 exchange. When you exchange property for a lump sum, it is a short term transfer and is considered a temporary sale. Holding onto the property for the entire period of the exchange gives you tax relief throughout the exchange.
If you want to get around paying Capital Gains Tax on your property for the duration of the exchange, you need to use the services of a qualified intermediary. Using a qualified intermediary can save yourself up to the first $20k in capital gains. You can find a qualified intermediary by asking your title company, real estate agent or mortgage broker. They will be able to advise you on the best way forward and help you with the paperwork required for the exchange.
Improved Cash Flow and Income
In addition to building wealth through capital appreciation, owning a property with positive cash flow is a great way to grow your money quickly. You can trade non-income-generating properties such as vacant land for commercial buildings or rental properties that provide you with monthly income and positive cash flow.
For Portfolio Diversification and Expansion
Owning only one asset, or several of the same types exposes you to more risk if the market goes down. Since you can diversify your assets and reduce the risk of owning only one or one type of property if you buy multiple properties through a single 1031 exchange.
If you decide to sell your rental property, you must recover the depreciation and pay taxes on it. It usually shows up at around 25%. With a 1031 exchange, depreciation is carried over to the replacement property and deferred until a taxable sale of the replacement property occurs.
For Tax-Free Transfer of Assets and Profits
We mentioned that the only time you’ll pay deferred taxes is when you sell. However, if an investor chooses to keep the replacement property for an extended period, in the event of death, the deferred tax is removed when the profits and property are transferred to your beneficiaries.
To Free Up More Capital
Tax savings mean more purchasing power is available for you to invest in other assets. You can take your cash and get a more expensive and high-value substitute, using the proceeds of the exchange as a down payment.