Capital gains taxes can be a significant burden for real estate investors and business owners, but with the right strategies, you can minimize or defer these taxes. We’ve compiled practical tips to help you navigate the complexities of capital gains taxes.
Capital gains tax can apply to various assets, including real estate and business sales, and it’s crucial to understand how to manage this tax burden effectively. In this blog, we’ll cover key strategies to defer or reduce capital gains taxes, from leveraging the 1031 exchange to structuring your business appropriately. These actionable tips will provide you with the insights necessary to plan your investments more efficiently and maximize your financial returns.
1. Understand the Power of the 1031 Exchange
One of the most powerful tools available to real estate investors is the 1031 exchange, which allows you to defer capital gains taxes when you sell a property, as long as you reinvest the proceeds into another “like-kind” property.
Here’s how it works: if you own a rental property and want to sell it to invest in a new property, the 1031 exchange lets you roll over the profits into a similar type of asset—real estate. You could upgrade from a duplex to a commercial property, land, or even an RV park. As long as the investment is in the same asset class, the gain from the sale can be deferred, essentially allowing you to grow your portfolio without paying taxes on each transaction.
However, note that this strategy only works for real estate transactions. If you sell real estate to buy a business without real estate, you won’t qualify for a 1031 exchange, and you’ll need to pay capital gains taxes on the property sale.
2. Leverage Depreciation in Asset-Heavy Businesses
When buying certain types of businesses, such as those with significant physical assets (like a dental practice or a laundromat), you can use depreciation to your advantage. Depreciation allows you to write off the value of these assets over time, which can reduce your taxable income and capital gains liabilities.
If you’re purchasing an asset-heavy business, consult with a CPA to strategically plan the depreciation schedule. It’s a powerful way to lower your taxes, especially in the first few years of ownership, and can make the transition from real estate to business ownership more tax-efficient.
3. Choosing the Right Business Structure: LLC vs. S-Corp
Choosing the correct legal structure for your business can have a significant impact on your tax liability, especially when it comes to capital gains. The webinar emphasized the importance of considering your long-term tax strategy when forming your business entity.
For operating businesses (like a laundromat or consulting firm), an S-Corp can be a beneficial structure. S-Corps allow business owners to save on self-employment taxes by paying themselves a reasonable salary and taking the remaining income as dividends. However, if your business nets less than $50,000 annually, this structure may not be advantageous. In contrast, LLCs are more straightforward and allow for flexible tax options.
It’s important to note that real estate investments should never be held in an S-Corp. Instead, use an LLC to own real estate, as this structure allows for better tax benefits and asset protection. Real estate held in an S-Corp can create unnecessary tax liabilities and complications when selling or transferring ownership.
4. Maximize Short-Term Rental Loopholes
For real estate investors looking to defer capital gains, short-term rentals offer a valuable loophole. By owning and actively managing short-term rental properties, you can bypass the need for real estate professional status (which requires 500 hours of active involvement annually) while still benefiting from tax deductions.
By materially participating in the management of your short-term rentals, you can use the losses generated by depreciation, expenses, and cost segregation to offset your W-2 income. This can drastically reduce your taxable income and capital gains.
One example shared during the webinar involved a client with an $850,000 W-2 income. After purchasing a short-term rental and conducting a cost segregation study, the client reduced their tax bill by over $100,000.
5. Use Partnerships Wisely
When investing in real estate with others, partnerships can be a great way to pool resources and grow your portfolio. However, partnerships come with their own set of tax challenges, particularly when it comes to claiming capital gains and losses.
Each partner’s ability to claim tax benefits, such as depreciation or deductions, is based on their active participation in the business. In a multi-partner investment, only one partner may qualify as the real estate professional, meaning only one can claim the full tax benefits of the property’s losses. Structuring your partnerships and ensuring proper time logs and documentation can help maximize the tax benefits for all involved.
To fully benefit, ensure that each property is placed in its own partnership or LLC. This way, losses and gains can be more easily distributed among partners based on individual involvement.
6. Take Advantage of Bonus Depreciation
Through 2027, business owners and real estate investors can benefit from bonus depreciation, a tax provision that allows you to deduct 80% of the cost of new equipment, property, or improvements in the first year of purchase. This deduction is especially useful for vehicles, equipment, and large assets that qualify for depreciation.
For real estate investors, this means that you can significantly lower your taxable income by conducting a cost segregation study on new properties. However, it’s important to consult with a CPA to ensure that bonus depreciation aligns with your overall financial strategy.
7. Keep Meticulous Records and Time Logs
One of the key takeaways from the webinar was the importance of keeping accurate records, particularly when attempting to qualify for real estate professional status. To claim this status, you must prove that you spend at least 500 hours a year actively managing your properties. The IRS requires detailed time logs, and failing to provide them could result in disqualification and an audit.
Time logs should include specific dates, tasks performed, and the amount of time spent on each task. Additionally, maintain digital receipts for expenses and any other supporting documentation in case of an audit.
Conclusion
Managing capital gains taxes can seem complex, but with careful planning and the right strategies, you can minimize your tax burden and maximize your wealth-building potential. From leveraging the 1031 exchange and short-term rental loopholes to structuring your business as an S-Corp or LLC, there are numerous ways to defer or reduce capital gains taxes.
Consulting with a knowledgeable CPA who specializes in real estate and small business taxation is crucial. With their expertise, you can create a strategic plan that aligns with your long-term financial goals and keeps more of your hard-earned profits in your pocket.
