Brian was interested in starting to invest in real estate to grow his retirement savings faster. He worked in a corporate job and his 401k savings were reasonable, but he wanted greater financial stability in his golden years. Curious but cautious, he sought me out during a social hour at our local investors club meeting to find out whether there were any tax liabilities that go along with real estate investing. Yes, I told him—while there are numerous ways to maximize your investment property tax deduction, you need to be especially aware of capital gains taxes. Here’s the quick lowdown that I gave him.
Capital Gains Taxes Don’t Have to Pinch Your Retirement Savings
Federal capital gains taxes apply whenever you sell a capital asset, like real estate, for more than you bought it for. The taxable amount is determined by your “cost basis,” as it is commonly known. The cost basis of your property is the original purchase price plus certain costs associated with the transaction such as settlement insurance and back taxes that you paid to the seller. You can also add many rehabbing or renovation expenses to your cost basis. To figure your capital gains liability, you simply calculate the difference between your cost basis on the property and the price you sold it for.
Sale Price – Cost Basis = Capital Gains
The capital gains tax rate you are charged depends on how long you held the property. However, you may be able to defer capital gains liability through a 1031( like-kind) exchange. This allows you to defer paying taxes on a property sale by reinvesting the proceeds in a similar property. Both properties must be held for the purposes of business or investment. Your primary residence or vacation home cannot be exchanged. In addition, the properties must be of the same nature. That is, you can exchange a single-family home for a vacant lot but not securities or debts.
Your tax professional can help you determine what qualifies and strategize the best way to handle a 1031 exchange if it applies to your situation, but you should reach out early because there are important time limits when completing the transaction. Currently, you must identify a new property within 45 days of closing on your sold property. Details matter here—you must also notify the seller of your intent to buy in writing and include a legal description of the property. Then, you need to complete the purchase of the new property within 180 days of the sale of your exchanged property or before that year’s income taxes are due (with extensions, if needed), whichever comes first.
Most real estate investors use a qualified intermediary or exchange facilitator to complete a 1031 exchange. Taking control of the proceeds from the initial sale may disqualify the entire transaction and make all capital gains immediately taxable. Currently, any professionals involved in a property transaction with you, such as a real estate agent, attorney, or accountant, within the past two years cannot serve as an intermediary for your 1031 exchange. Always choose an experienced and reputable intermediary, as there are reports of some “professionals” going bankrupt or not otherwise meeting their contractual obligations and leaving investors with a hefty—and unexpected—tax burden.
There are additional cautions you should know before entertaining the idea of a 1031 exchange. Most importantly, you should know that 1031 scammers abound. You may come across some individuals promoting inappropriate ways to use a 1031 exchange. Their sales pitches often encourage you to take advantage of the tax benefits for properties like vacation homes that don’t qualify. Others will frame the 1031 exchange as “ tax-free” when it is only a way to defer taxes. You may also be advised to claim an exchange even though you did not use an intermediary to handle the sale proceeds. These folks are usually not tax professionals and their input should be taken with a grain of salt.
You don’t want to land on the bad side of the IRS when it comes to taxes, so it’s important to plan your real estate investing strategies in consultation with a tax professional before engaging in a 1031 exchange. However, when done correctly, exchanging properties through a 1031 transaction can potentially help you grow an investment portfolio and defer property taxes until you retire, when your taxable income bracket may be lower than it is now.
Ethical Real Estate Investing for Retirement
Real estate investing can be rife with ethical issues, especially when it comes to being honest in financial dealings. When I meet with new investors like Brian, it just doesn’t surprise me anymore how much bad advice they encounter. The unfortunate ones actually follow that bad advice and end up in over their heads. That’s why I give them my best piece of advice: become a HomeVestors® franchisee. New franchisees are trained on how to build a strong and ethical real estate investing business from the start. With an experienced Development Agent mentor to offer guidance and a network of other franchisees with whom you can share experiences and challenges, purchasing an independently owned and operated HomeVestors® franchise is an effective way to ensure that you maintain sound practices while developing a retirement nest egg.
Each franchise office is independently owned and operated.