When it comes to income and investing, understanding how timing affects your taxes is a big deal.
Let’s say you take a trip to Las Vegas to celebrate the coming of the new year. You head to the casino and at 11:00 pm on New Year’s Eve you win a $2 million jackpot. You keep gambling and by 8:00 am on January 1, you’ve lost it all. Easy come, easy go, right? Wrong. The winnings are taxable; the losses are not deductible. You won $2 million in 2023 and lost the money in 2024. Your winnings are taxable (a 28 percent tax would amount to a $560,000 tax bill from Uncle Sam), but the loss is non-deductible.
Now you understand why timing is important when it comes to taxes.
Let’s bring this into the real estate realm and how the timing on buying and selling property—especially investment property—can affect your taxes.
Defer Capital Gains Taxes
When you sell real estate, you typically have to pay capital gains taxes on the increase in value between the time you bought the property to when you sell it. One way to defer capital gains taxes is by using a 1031 exchange, whereby you can sell your current property and buy another one and trade the equity in your current property (the amount you own free and clear) for the equity in the new property. Here’s the catch, you must complete the transaction according to a strict timeline and set up the exchange prior to the close of escrow of your current property.
I’ve had folks come in two weeks after their property sold asking for help finding a new property for the exchange. At that point, it’s too late. Those two weeks could cost hundreds of thousands of dollars in tax liability. It doesn’t matter if the money from the sale is untouched and still in an escrow account. Once the escrow closes, the window for the exchange is closed.
Another common mistake with exchanges is missing a deadline for part of the transaction. With 1031 exchanges, you have 45 days to identify the property or properties you plan to buy and 180 days to close escrow on those properties. Some unfortunate investors have found out the hard way that 180 days is not the same as six months—six months is too long.
Another way to minimize paying capital gains taxes is by using investment losses to offset investment gains. Let’s say it was a crummy year in the stock market and the value of your portfolio is down. If you sell real estate for a gain during that same fiscal year, those stock losses can help reduce your overall tax burden.
When it comes to selling a single-family home, the government allows a capital gains tax exemption on the first $250,000 (for an individual) or the first $500,000 (for a couple) as long as the individual or couple lived in the home for two of last five years. This exemption does not apply for investment properties–but the tax basis of the investment property can change if one of the owners dies.
I was working with a very elderly couple, in their 80s and 90s, and the husband’s health was declining. He wanted to sell their investment property so his wife would have cash to live out the balance of her days in comfort. The problem was that if they sold the property prior to his passing, they would have had to recognize a significant capital gain and the tax liability would have exceeded the amount of equity in the property. If they waited until his passing, she would get a stepped-up basis in the property and be able to sell it with no tax liability at all. Sometimes this is a hard discussion to have, but a critically important one.
Next week, I’ll talk about using cost segregation to minimize your tax burden on investment property. If you’d like more information on 1031 exchanges or stepped-up basis, visit selzerrealty.com/mendocino-county-real-estate-blog. In the meantime, if you have questions about property management or real estate, please contact me at email@example.com or call (707) 462-4000. If you have an idea for a future column, share it with me and if I use it, I’ll send you a $25 gift certificate to Schat’s Bakery.
Dick Selzer is a real estate broker who has been in the business for more than 45 years.