Building a portfolio of investment properties can be exciting. The sky’s the limit with the possibilities of appreciation and cash flow, and you can almost taste the success. After you get a few properties under your belt, you may decide to sell off one or two of the lower-producing rental properties and use that equity to purchase a larger investment with higher returns.
However, when you go to sell you might discover that taxes and commission take a big chunk of the money you’ve earned, and suddenly the sale doesn’t seem so appealing any more. So, what do you do? Is there any way for you to avoid taxes when you sell a rental property?
How much tax will I pay when I sell my rental property?
The tax we are referring to is called Capital Gains tax. It only occurs when you sell an asset for more than you acquired it for, making the income you get from the sale the capital gains. You can avoid the tax if you have owned and lived in the house for two years within a five year period of the sale and you haven’t excluded another home’s sale from taxes within that two year period.
If this doesn’t apply to you, then you will be responsible for paying the tax. It depends on your level of income, but as of 2018, the Capital Gains tax rate tops out at a whopping 37 % if you’ve owned a property for less than one year, and 20% if you’ve owned it for more than a year. So, if you received $100,000 profit from the sale of the house, up to $37,000 would be taxed if you were in the top tax bracket and owned the house less than a year, and $20,000 if you owned the house less than a year.
Can you avoid capital gains tax on a rental property?
The short answer is yes, but it takes a lot of work, and it might require you to purchase another investment property. However, when we’re talking about taxes on hundreds of thousands of dollars, many sellers are willing to put whatever work is required to avoid taxes.
This can be done by either a 1031 exchange if there’s a profit, or tax loss harvesting if you have a loss on your property.
What is a 1031 Exchange?
A 1031 exchange is basically a way of selling one investment property, and using all of the proceeds to exchange into another investment property or properties. You do this to avoid substantial tax implications from the Capital Gains Tax. Essentially, you are changing the form of your investment without cashing out or recognizing capital gain. Without any real monetary gain on the property, you won’t have to pay the taxes.
Growing Your Investment Portfolio Using A 1031 Exchange
Many savvy investors use the 1031 exchange to rapidly scale their investment portfolio without paying taxes. Here is a real life example of how a 1031 exchange can be used to turn one 4 family property into 18 units.
Clever’s founder, Ben Mizes, had a 4 family home that he purchased 15 months ago in a rapidly appreciating area. Over the course of a year he did several improvements and upgrades, and raised rents when tenants moved out.
One year later the property was worth close to $80,000 more than he paid for it. Selling the building would result in close to $20,000 in taxes, drastically reducing his profits.
Ben sold the property through clever to save on commissions, and used a 1031 exchange to avoid paying taxes. He took the $80,000 and used it as the down payment on an 18 unit package.
His first building had a cash flow of around $800 a month, and the 18 units provide close to $4,000 in cash flow. Without a 1031 exchange Ben wouldn’t have been able to afford the 18 units, and would still own the small 4 family building.
1031 Exchange Rules
If you’re thinking of doing a 1031 exchange, there are several important rules you must abide by.
Most importantly, you have 45 days to identify your next property or properties after you close, and must close within 180 days. You also to purchase a property or properties worth more than the property you’re selling.
Clever has written an in depth guide on all of the 1031 Exchange Rules and guidelines. If you’re thinking of doing a 1031 exchange, this guide will teach you everything you need to know.
Ready To Start A 1031 Exchange?
If you’re looking to open an exchange, Clever has partnered with a 1031 Exchange Advantage to offer a 1031 Exchange for only $595. 1031 Exchange Advantage is a full service, qualified intermediary that has completed hundreds of exchanges.
You can schedule a free consultation with our partner here.
Tax Loss Harvesting
If the property you want to sell has depreciated to the point of it being a loss for you to sell it, you can claim a tax loss and not have to pay Capital Gains.
When the property sells you get credits for the loss that go toward your capital gains on the property. If you are not able to purchase a nearly identical asset within 30 days before or after the sale, you will be subject to the Wash Sale Rule. If you are subject to the Wash Sale Rule, you will be disqualified from harvesting a loss and must pay up. It’s important to speak with your accountant to make a plan before attempting any tax loss harvesting.
Selling With A Reduced Commission Real Estate Agent
If you’re doing a 1031 exchange to save on taxes to buy a larger property, saving on commissions when you sell is also a great idea.
If you’re buying your next property with a conventional 20% down mortgage, every dollar you save on commision when you sell generates 5 dollars of buying power for your next property.
Clever Real Estate offers local, full service agents that will list your home for a flat fee of $3,000 if the home is less than $350,000, or 1% if the home is more expensive. You will still receive all of the same service you would expect from a traditional agent.
Working with a Clever agent and doing a 1031 Exchange can drastically increase your buying power, making it easier to rapidly grow your portfolio, and achieve financial freedom.
Need help purchasing a home with a 1031 exchange? We know a guy. Actually, we know several who happen to be in your area. Our top local agents not only know what it takes to serve you, but they also do it at a discount rate. Call 1-833-2-CLEVER or complete our online form to get connected a top-rated local agent that will list your home with a discounted commission rate.