Protecting your Capital Gains
A friend told me about someone they knew who had a capital gain of $1M after sale of a multifamily property. Big celebration, but unfortunately in these circumstances that person was not able to plan for deferring the taxes on that gain. Have you had a real estate gain you decided to just pay taxes on?
We have a few hugely valuable options when selling properties to defer the capital gains, including 1031 exchanges, IRS 453 tax deferrals, and opportunity zone investing. But often they are not the right fit.
First, I’m not an accountant. I utilize the best accounting resources and they have saved my bacon more than once, so verify anyone’s tax saving suggestions, including mine, with your accountant.
Would you like to just pay $200,000 in taxes on a capital gain like that, rather than risk getting in trouble with the IRS? Maybe you would, but you have to keep in mind that Congress wants to encourage certain behaviors. That’s why they passed the laws that say if you behave this way, you are entitled to save or defer some taxes. It’s not cheating, it’s not unethical, it’s not a loophole. It was designed that way. The behavior they are encouraging makes good things happen, like more housing.
Here’s a simple option. Invest your proceeds in another property the same year. Get it into a deal, fast. Don’t cram into the first deal that comes along, but get to know who the best syndicators are. One of them is likely to have a good deal offering before the end of the year.
Then study their materials and confirm they intend to do cost segregation on their new acquisition this year, the same year they purchase. With cost segregation comes bonus depreciation. Cost segregation is an engineering and accounting activity that allows all of the component assets within a real estate property, including the countertops, floors, appliances, etc., to be recharacterized for depreciation purposes as potentially shorter lifespans. So instead of depreciating your property on a 27.5 year straight line schedule, you’re able to take most of the depreciation the year you purchased it. Who owns a property for 27.5 years anyway.
I see most properties who perform a cost segregation able to deliver a depreciation deduction to their investors of 60-80% of their initial investment. If it’s highly leveraged, which unfortunately most properties these days are not, the depreciation deduction could be even higher.
You take your $1M gain from the property you just sold, invest it in a property doing cost segregation, and most of your gain is sheltered by the depreciation deduction on your new property.
Special considerations? Yes, a few. First is that the Bonus Depreciation benefit is being phased out. You can only deduct 80% of that depreciation in 2023, then 60% in 2024, 40% in 2025, etc. Unless they change that law, which hopefully they will. Still, 80% of the full depreciation is pretty awesome.
And why not? You keep that $200,000 you were going to pay the IRS and you invest it again into more real estate. Your motive may be to build your personal wealth but the net effect is it adds significant tangible support to real estate values. It is only through this process of having a low-friction free market of real estate purchases and sales that new development comes into the market. Developers will not build in an area if they believe there won’t be a buyer some day who will buy it from them, at a profit to them.
Invest your time now to find several syndicators who have demonstrated they are out buying, doing well for their investors. Can’t find one? Then check with financial advisors and find companies who manage and offer Delaware Statutory Trusts. Returns are a little lower but they can get your money into a tax deferred real estate investment pretty quickly.
Anything to defer those taxes and keep your money growing.