HOW TO DEFER TAXES ON HIGHLY APPRECIATED REAL ESTATE
How to Defer Taxes on Highly Appreciated Real Estate
With the recent increase in home prices, many people may want to cash in on the value of their home. That might mean downsizing and pocketing the difference, or selling a second home to fund retirement. But nobody wants the government taking a large share. So what are the tax consequences, and what can be done to reduce them?
Tax on the Sale of Real Estate
As a general rule, profits on investments are taxed. If you buy vacant land for $40,000 (your basis) and sell it for $50,000 (the amount realized), you pay capital gains tax on the $10,000 profit.
What Is Basis?
Your basis is generally what you paid for the property, plus certain closing costs such as legal fees and transfer taxes. Indirect costs like homeowner’s insurance or mortgage fees are not included.
For homes, basis can also include capital improvements like a new roof or garage, but not routine maintenance. Any casualty losses previously deducted must be subtracted.
In short, basis equals purchase price plus improvements, minus prior deductions or losses.
What Did I Realize?
Capital gains equal the amount realized minus your basis. The amount realized is not just the cash received — it also includes any mortgage paid off at sale.
For example, selling a $500,000 home with a $300,000 mortgage and $25,000 in commissions results in $175,000 cash received, but $475,000 realized.
How Much Tax Do I Owe?
It depends.
Short-term gains (property held less than one year) are taxed as ordinary income. Long-term gains are taxed at lower rates, generally 15%, or 20% for higher-income earners.
Primary residences receive an exclusion: $250,000 for singles and $500,000 for married couples if lived in 2 of the last 5 years.
Do I Have to Pay All That Tax?
Sometimes yes — sometimes no. Long-held properties can trigger large gains, especially for widows or investment property owners.
Solution #1 – 1031 Exchange
Available only for investment property. By reinvesting proceeds into a new property within 180 days, capital gains taxes can be deferred.
Solution #2 – Step-Up in Basis
When a property owner passes away, heirs receive a step-up in basis equal to the property’s value at death, often eliminating capital gains.
Solution #3 – Deferred (Installment) Sale
Installment sales allow sellers to receive payments over time, spreading capital gains tax across multiple years and potentially lowering the tax rate.
Warning Regarding Deferred Sales
The IRS actively challenges abusive monetized installment sales. Structures created solely to avoid taxes may be disallowed.
Always have independent counsel review deferred sale arrangements.
Solution #4 – Gift to Charity
Donating appreciated property allows the charity to sell tax-free while providing the donor a charitable deduction.
Solution #5 – Partial Gift to a Charitable Remainder Trust (CRT)
A CRT allows partial donation, income to the seller, and tax benefits. While complex, it can significantly reduce capital gains taxes when structured properly.
Income from the trust is taxable, but may fall into lower tax brackets depending on overall income.
