Selling Your Investment Property? Here’s How to Avoid Capital Gains Tax

1031 Pros
Apr 7
5 min read

If you’re wondering how to avoid capital gains tax when selling an investment property, you’re not alone. Many investors wonder about how to keep the tax man at bay when it’s time to offload an underperforming asset.

Several methods are available, including a 1031 exchange, a conversion, and tax-loss harvesting. We’ll explain how each one works and help you make a smart decision for your portfolio.

What Is an Investment Property?

It’s important to have a good baseline of information before you dive in. Let’s start with a few definitions, so you know exactly what we’re talking about and why.

Cornell Law School defines an investment property as one that was purchased with the specific intention of profit. Investors might make that profit through rental income, resale, or capital gains.

An investment property isn’t one that you live in full-time. It’s also not one that you purchase as a gift for someone else (such as an apartment you let your sister live in rent-free).

When you sell an investment property, you’re typically hit with capital gains tax. The larger the gap between the purchase and sale price, the larger the tax. Most investors pay a tax between zero and 20% on that amount. Let’s dig into how to avoid capital gains tax when selling an investment property.

Consider a 1031 Exchange

The simplest and most effective way to avoid paying immediate capital gains taxes is to use a 1031 exchange. The IRS has detailed rules about how these transactions work. Knowing about these rules can help you understand what makes them different from a standard real estate transaction.

Deadlines

On the day you sell your property, it’s time to watch the calendar. You must meet two very important deadlines, and they can’t be shifted. They are as follows:

45 days: On or before this deadline, you must provide written identification of the property (or properties) you will purchase in the exchange.
120 days: On or before this deadline, you must complete the purchase of the property (or properties) and take possession.

A standard transaction can move as quickly or slowly as the two parties might like. However, an exchange must involve these deadlines, and there is no room to move them.

Linked Transactions

The IRS clearly states that these two deals must be linked. An investor isn’t just selling one property and then buying another. Instead, you are making one transaction that involves two moving parts. One cannot happen without the other.

Qualified Intermediary

In a normal real estate deal, the profits can move directly into your bank account. A 1031 exchange is different. If you accept the money or touch it in any way, the sale becomes taxable.

To avoid this problem, you must hire a qualified intermediary (QI). This person accepts the funds from the sale and holds them for the purchase of the new investments.

Investment Only

In a typical real estate transaction, you can sell or buy anything you’d like. However, a 1031 exchange is made for investment properties only. You can’t sell something like a parking garage and use the proceeds to buy a home that will serve as your primary residence.

Deferred Capital Gains

The potential capital gains from the sale of your property don’t go away in a 1031 exchange. Instead, those taxes are wrapped into the basis of the new property. If you sell it at some point, you will be required to pay those taxes.

Convert Your Investment Into a Home

Still wondering how to avoid capital gains tax when selling an investment property? Conversion is another smart choice. With this method, you’ll slowly transform your investment property into the place you call home sweet home.

In many parts of the country, the housing market is tight. Experts say the problem started during the pandemic, and recovery has been slow. Mortgage rates are high, and some homeowners are reluctant to sell without the promise of a new property they can buy. If you’re in a market like this and own a rental home you could live in, this might be a smart choice.

After converting your rental into a primary residence, you can sell it. At that point, the IRS explains, you can exclude $250,000 of that gain from your income as a single person ($500,000 if you’re married filing jointly).

Here’s how you might take advantage of this opportunity:

Choose the right time. If you experience high renter turnover, move in when the last renters depart.
Make a paper trail. Transfer the utilities to your name and ensure the postal service delivers mail to you.
Maintain records. To complete the conversion, you must prove that you’ve resided in the home as a primary residence for a minimum of two of the five years before the sale. Those two years can be non-consecutive. Ensure you can meet this requirement before considering the sale.
Put the home on the market. After you ensure that you can meet the residency requirement, you can sell the home.

When it’s time to complete your taxes, you can take the residency exclusion and eliminate part (or all) of your capital gains taxes. Ensure that your paper trail for residency is solid, so you have proof if you’re asked for it.

Know that this approach won’t work for all types of investment properties. For example, you can’t move into a parking garage or grocery store. You also can’t take over every unit of an apartment building. However, it can be a smart way to deal with a single-family home.

Consider Tax-Loss Harvesting

There’s one other option to consider to lower your capital gains tax. It involves looking over all of your investments and spotting one that isn’t serving you well. If you sell this asset at a loss, you can use it to offset the capital gains from the sale of your property. This method is called tax-loss harvesting.

Here’s what to do to make tax-loss harvesting work:

Examine your assets. The IRS explains that you can only deduct your capital losses on investment property, not personal ones. That means you can’t sell something like your family’s heirloom dining room table and call that a loss. Instead, you must sell something you’re using as a business asset. That might mean something like another property or stocks that your business owns.
Sell at a loss. To make this method work, you can’t make a profit on the sale. Instead, you need to lose money on the sale when compared to the purchase. Ideally, you’ll lose more than you gained on the sale of your property.
Talk to a professional. There are risks involved with this method. Ensure that you’re working with a tax expert and handling each step perfectly. An expert’s guidance can help you avoid costly mistakes.

Expert Help With Your Exchange

We’ve outlined several methods you can use to circumvent capital gains taxes on the sale of an investment property. There’s one method we specialize in. At 1031 Pros, we focus exclusively on 1031 exchanges for investors just like you.

We can help you understand how these transactions work, why they might be smart for you, and what potential risks are involved. We can also handle your transaction as a qualified intermediary. Your investment and financial future are in good hands with us. Contact us and we’ll get started.