By using smart tax strategies and staying updated on tax laws, investors can improve their investment outcomes. For private real estate investors aiming to boost profits and reduce taxes, understanding capital gains taxes and the role they play in investments is important.
Before jumping into capital gains taxes, let’s start by clarifying what constitutes a capital gain. In the world of investments, a capital gain refers to the profit earned from the sale of a capital asset such as a stock, bond or real estate. When the selling price exceeds the purchase price, the difference represents a capital gain. For example, if an individual buys a property for $250,000 and later sells it for $400,000, the $150,000 difference is considered a capital gain.
Short-Term Vs. Long-Term Capital Gains Taxes
Capital gains taxes are imposed on the profits generated from the sale of capital assets, in this case real estate. States tax capital gains differently (use this tool to find each state’s capital gains tax rate). At the federal level, taxation of these gains is contingent upon various factors, including the duration of ownership and the investor’s income bracket.
Short-term capital gains: These are assets held for one year or less before being sold. They are taxed at ordinary income tax rates, which can range from 10% to 37%, depending on the taxpayer’s income. Let’s say on Jan. 1 you purchase shares of XYZ stock for $20,000. On June 1 you sell those shares of XYZ stock for $30,500. The short-term capital gain is $10,500.
Long-term capital gains: These are assets held for one year or more before being sold. They are taxed at the long-term capital gains tax rate, which can range from 0 to 20% depending on the taxpayer’s income. For instance, let’s say an investor purchased shares of XYZ stock in 2020 for $20,000. In 2023, they sold the shares for $30,500. The long-term capital gain is $10,500.
Additionally, high-income earners might be subject to a net investment income tax (NIIT) of 3.8%, which could impact the overall capital gains liability. The NIIT is calculated by adding up all income you earned from investments in the applicable tax year less any expenses.
2 Strategies to Avoid Capital Gains Taxes on Real Estate
Capital gains taxes are an inevitable reality of real estate investing. But investors can employ a couple of strategies to minimize the burden.
Qualified Opportunity Zones (QOZs): investing in QOZs allows investors to defer capital gains taxes. By investing capital gains into Qualified Opportunity Funds, investors can benefit from tax incentives offered under the Opportunity Zone program. Investors have 180 days from the realization date of the gain to invest in a QOZ fund. You can learn more about Origin’s Opportunity Zone III Fund here.
1031 exchange: Under section 1031 of the Internal Revenue Code, investors can defer paying capital gains taxes by reinvesting the proceeds of a property into a like-kind property. This strategy allows investors to defer taxes indefinitely as long as they continue to reinvest in qualifying properties. Investors have 45 days from the point of sale to identify the replacement property. In all, they have 180 days to complete the exchange.
Capital gains taxes can have a big impact on an investor’s income and returns. Understanding how they work—and knowing when they are realized—is a critical part of an overall investment strategy. By structuring your investments to account for capital gains taxes, you can keep more investment profits for yourself.
