When you sell an asset for more than you originally paid for it, your profit is called a capital gain. Capital gains are taxable at a rate based on how long you hold the sold asset. If you’re looking to realign or balance your real estate portfolio, you can effectively swap properties and defer paying capital gains tax through a 1031 exchange, where you reinvest the proceeds from a property sale in another like-kind property.
When part of an estate-planning strategy, a 1031 exchange can be a tax-smart method of bequeathing assets, as heirs typically receive a step-up in basis to the property’s fair market value as of the date of death. This can effectively eliminate the capital gains tax deferred through the 1031 exchange.
Key Takeaways
What Is Capital Gains Tax Deferral?
Capital gains tax deferral refers to the practice of delaying the payment of taxes on proceeds from the sale of assets, such as properties and other investments. With real estate investments, deferring your capital gains tax gives you an advantage by increasing your purchasing power. If you don’t owe tax immediately, you can put all the proceeds of a property sale toward another investment property type.
Deferring Capital Gains Tax With a 1031 Exchange
One of the ways you can defer capital gains tax in real estate is to conduct a 1031 exchange. In this process, you sell one property (the relinquished property) and roll over the proceeds into the purchase of another property (the replacement property). A third-party qualified intermediary holds the funds in escrow for you, so you never take receipt of the proceeds. The money remains within an investment, which isn’t taxable.
For a 1031 exchange to be valid, you must also meet certain conditions set forth by the Internal Revenue Service:
If you satisfy the above requirements, you could use 1031 exchanges in perpetuity, continually trading up on properties and deferring the capital gains tax every time.
What Is Step-Up in Basis?
Step-up in basis, or stepped-up basis, refers to an increase in an inherited asset’s value compared to its original value at the time of purchase. In the investing arena, the term basis (or cost basis) means an asset’s original cost to the investor. That figure determines the amount of capital gain when the investor sells the asset at a profit and the capital gains tax they owe.
Upon the investor’s death and subsequent inheritance by their heirs, an asset’s basis steps up (increases) to reflect its current fair market value. So, if an investor purchased a rental home for $100,000 in 2000 and the property appreciates to $500,000 when the investor passes away in 2023, then the home’s cost basis would reset to $500,000 when ownership transfers to the heir.
To understand the connection between capital gains deferral and the step-up in basis, let’s revisit the investor who purchased the $100,000 rental home in 2000. However, this time, let’s say they acquired the property through a 1031 exchange and deferred the capital gains tax.
The capital gains deferral benefits the investor while they hold the 1031 exchange property. If the property remains profitable, they might hold on to it for the rest of their life, or they could conduct a 1031 exchange to swap it for another property that better aligns with their investment goals. If they continue to use the 1031 exchange provision in either manner, they could feasibly defer capital gains tax until death. According to the current tax laws, death would erase the capital gains tax due.
Upon the investor’s death, ownership of the property transfers to a named heir. The cost basis then steps up to reflect the current fair market value of the property, which is $500,000. If the heir sells the property for exactly $500,000, they owe no capital gains tax because they technically realized no gain. There’s also no capital gains tax “left over” from their benefactor since the tax liability doesn’t transfer.
A new capital gains tax doesn’t apply until the heir sells the property for a profit. Even then, the taxable amount would be the difference only between the sale price and $500,000.
Estate planning is one of the many financial services we offer at Anderson Advisors. Whether you’re looking to avoid capital gains tax on real estate, optimize wealth transfer to your heirs, or realize any other kind of estate goal, our expert advisors can provide you with the guidance you need. Call 800-706-4741 or complete our online form today to schedule your complimentary 45-minute estate planning strategy session.
https://www.youtube.com/watch?v=z2OFM3UEUJM&t=1s
The presentation is focused on understanding how to minimize taxes effectively, primarily by exploring the three different types of income: active income, portfolio income, and passive income.
Active Income: This type of income includes wages or salaries and is subject to ordinary tax rates as well as social security taxes. The speaker emphasizes that even if people believe they don't pay income taxes, they are still subject to social security taxes, which can be a significant portion of their earnings.
Hey guys, Toby Mathis here with Anderson Business Advisors. And today we're going to talk about how to pay zero taxes in 10 minutes or less. Alright, let's dive on in.
Number one, in order to understand how to pay less tax, you've got to understand how taxes actually work. And my experience is that 99.9% of the people out there have no flipping clue. And that includes a lot of the tax practitioners, unfortunately. And here's where we're going to start. We're going to do the 10,000-foot view. Now we're going to be specifically drilling into capital gains in this particular video. Although there's lots of others, you can look on YouTube. You're going to see that we have a lot of content on my channel that'll show you how to eliminate tax, but you have to understand how all the taxes interrelate. And so I'm going to focus on the different types of taxes. There are actually three types, three types only. Anybody starts telling you differently, it's because they just don't know. There are three broad overlying factions of these.
So number one, I'm just going to call it active. And we'll just say active income. Number two, and this active income, it's the worst possible tax treatment you can receive. Active income is subject to, and I'm going to put it in red, ordinary rates, plus social security.
Here's how bad this is. Of all the taxes we collect every year, in the United States of all the taxes we collect. That's income, old age, disability, survivors, Medicare, all that good stuff, estate taxes, corporate taxes. This accounts for a little bit over 88%. You work at McDonald's and somebody who's going to run around and say, you don't pay any income taxes. That's absolutely- That's a lie. That's a lie that's been repeated so often that people actually believe it. You're not paying the income tax, the federal income tax at the ordinary rates, but you're definitely paying that 15.3%. The employer pays half, you pay half on old age disability, survivor's insurance and Medicare.
If you're self-employed, "Hey, I'm a little guy that's running a plumbing company" and you say, "Oh, your taxes were so low you had a standard deduction, you barely paid any tax at all." Complete fabrication, you're paying self-employment tax. Same thing, that social security is also called self-employment tax. Same thing, you're paying 15.3%. You make a hundred grand, over $14,000 is going to leave your pocket, going to just that little guy. And what's sad is this is really the only place that exists. So it is the worst possible treatment. When I worked for McDonald's, I was 16, I was making four bucks an hour. I was paying this tax. They would withhold from me and I get a refund on my federal taxes because I didn't make above the standard deduction or I was in a super low, uber low bracket, like 10% and they're withholding over 20. So I'd get some refund and I'd be like, "Yay, I got some refund." Make no bones about it. We're paying, if you're getting a wage, if you're getting a salary, you're paying taxes, period. They lie about that all the time.
Portfolio Income (no social security tax): Portfolio income consists of various sources like royalties, interest, and dividends. While it is taxed as ordinary income, it doesn't incur social security taxes. This section delves into the potential tax advantages of dividends, which can be taxed at different rates depending on one's income level.
Number two is portfolio. And portfolio income, there's several types that I'll go into, but what's most important is there's no social security tax. There's a way if you screw up or you do something that becomes your business, to turn portfolio income into active income. But for my topic today, I'm not going to dive in those weeds. I'm just going to say, as a general practical matter, this is royalties, Like, "Hey, I have a- Wrote a book or I have software out there, I'm getting a royalty." It's going to be taxed as ordinary income, but no social security tax. I have interest. I loaned money to my buddy or I'm loaning money to somebody. And they're paying me back that interest, that's taxed, no social security tax, it is subject to ordinary tax. And then we get into some cool ones, dividends. So dividends equal a tax treatment called long-term capital gains. And this is why that's important. These are taxed at zero, 15 or 20%. Long-term capital gains rates. Which means they're treated preferably. And again, no social security.
Hold on for a second, what's a dividend? If you own securities like, "Hey, I own a piece of, let's say Apple." I buy some stock in Apple and they pay me a dividend every year or Procter & Gamble or 3M or Coca-Cola or Chevron or Verizon or AT&T. All these companies pay dividends out to their shareholders because you're a shareholder. They're sharing the profit with you. That could be taxed at zero. Like again, if I was at McDonald's, working at McDonald's, I'm up here, I'm paying social security and I'm paying ordinary tax rates, that stinks. But if I have dividends coming in, I'm smart enough and I started accumulating a portfolio. Zero, I'm not going to be paying tax on that. If I make a whole bunch of money like, "Oh, I'm made 100,000, 200,000, $300,000 a year, I might pay 15%. You make $10 million a year and you have dividends, it's taxed at 20%. Now there's a net investment income tax that raises it to 23.8. If you hear anybody say 23.8, it's because they're adding in the surcharge, but that's pretty darn potent.
Capital Gains: Capital gains are discussed in detail, particularly long-term capital gains, which are taxed at lower rates (zero, 15, or 20%). The speaker explains how capital losses can be used to offset capital gains, providing a strategy for minimizing taxes. He suggests ways to generate capital losses, such as selling assets when their value decreases temporarily.
And then you have capital gains. And the long-term, I just told you, if you hold something over a year, where if you do futures, 60% of it's treated as long-term, it's that long-term, if it's short term, all of these, this one, this one, this one, they're all ordinary. They're all added up into your ordinary bracket.
Now, why is this important? These little guys down here, capital gains. Capital gains get offset by capital losses only. Capital gains get offset by capital losses or better yet, capital losses only offset capital gains. Except that if I have excess capital losses. So let's say I lose money on a security. So I buy a stock, Dejour, and I lose $10,000. I'm limited to use that $10,000 against other capital gains, but I could take $3,000. See if I can put up the right numbers, $3,000 a year against my active ordinary income or other income sources. So it's actually pretty potent. When you start looking at these things to how do I eliminate capital gains, one of the first ways you eliminate capital gains is by generating capital losses on other capital assets. So for example, I have a whole bunch of stock gain, great, watch, but I have Bitcoin too. Sell your Bitcoin when it goes down that 30%, like if the does this like Bitcoin's, it goes up 30, down 30, all over the place. When it goes down, just sell it, great, buy it right back. Now I have a capital loss, but I own Bitcoin still. I can take that loss and offset my gain. That's number one.
Number two is don't sell things. If you have a capital asset, you can borrow against it. So there's something called a security backed line of credit. They call it bank on me nowadays. They're talking about all the ultra wealthy, like Elon Musk, he's got billions of dollars of stock, right? He doesn't pay any taxes, why? Because he doesn't sell a stock. He borrows against it. "Hey, give me a loan, I won't default. But if I do, you can take some of my stock" I got billions of dollars of stock. So give me a few million dollars of line of credit. You don't pay tax on that.
If you have real estate, you have 1031 exchanges. I don't have to pay tax, I just keep buying more, 1031 exchange. Or take any capital gain and I can invest it in a qualified opportunities. And I could defer it. Like there's lots of different ways to not pay any tax. Once you understand where it sits.
Tax Strategies: The presentation introduces several tax-saving strategies, including borrowing against assets instead of selling them to generate income, utilizing 1031 exchanges in real estate transactions to defer taxes, and investing in qualified opportunities to defer capital gains. The focus is on avoiding the sale of assets, which triggers taxes.
Passive Income: Passive income is classified into two categories: rental income and income from businesses in which one has no material participation. Rental income is typically considered passive, and the speaker mentions the potential tax benefits associated with it, including depreciation and other deductions. Income from passive businesses is also discussed, particularly how wealthy individuals may invest in such businesses to offset their other income sources.
Now you notice I said there were three types of income. So here's the third. And it's called passive, passive income. Passive income, there's only two types, really simple. The two types, number one, rents. Rents are always considered passive unless it's not rent. So for example, like if you're doing an Airbnb and it's seven days or less average tenancy, the regs say that's not rent, but if it's rent, it's passive, period.
It ends up being really cool because passive income again is ordinary, but no social security, hopefully you guys can see that. No social security. So it's really, really all of these down here, you start realizing, "Wait a second, if I don't want to pay a lot of tax, maybe I should be making tax- Maybe I should be making my income here and here, duh."
The wealthiest people making over a million bucks a year, guess where up to 96% of their income comes from. Two and three, less than half on average comes from one. 'Cause it's the worst tax treatment. But so I said two, there were two types of passive income.
The second is businesses in which there's no material participation. So I'll just say businesses, silent. I won't give you the technical rollout, but it's businesses that you do not materially participate in. It just means you're a silent partner in a business, you don't do anything in the business.
So immediately you start thinking of rich uncle Ned or whoever it is, rich aunt Sally. And hey, they're always investing in businesses, but they don't want to be any part of it. It's because they probably have a whole bunch of rents coming in and they're thinking, "How do I not pay tax on the rents? I'll go into these passive investments in startups. And I'll generate a bunch of loss in the first year or two years and it will keep me from having to pay tax on this."
The other thing they do is they say, "Hey, if I have rents, I have huge depreciation, I have all sorts of tricks up my sleeve. I can accelerate my depreciation, I can use bonus depreciation, I could do cost segregation. I could do a lot of fun stuff. I could borrow against the asset, not pay any tax. I have all these tricks in my toolbox. I got 1031 exchanges. I got to step up in basis when I die so nobody ever pays tax on it." Like I have all these little tricks floating around up here. If you pay tax on rents 'cause you're not trying hard enough to not pay tax on your rents. There's always a way to not pay tax on rents.
So we start looking at this, our three types of income. And immediately we realize that, "Boy they're treated so differently." They're treated so differently, why are not more people going into this?
Well, the two best tax treatments, capital gains, long-term capital gains specifically, and the rents, there's a little nuance, which is they limit the losses against that same type of income.
So for example, on the passive, that's a little bubble. They can only offset each other with very few exceptions. So if I have a whole bunch of losses that I generate on my rents, I can offset other income that's coming in off of my silent business ownership.
But what I can't do is take all that loss and use it against my active income, unless, there's a couple of ways to do it, a real estate professional and active participant.
But for the most part, normal people, you're just going to be stuck there. You don't lose it, you just carry it forward and it keeps offsetting that income. Which is why the wealthiest people tend to get stuck in that bubble. And they're are always doing that. Like, "Hey, I don't want to participate. Hey, I don't want to do this. I just want to buy and I want rent.
So, hey, I want to open up a business, will you give me a bunch of money?" And they might be like, "Well, hold on for a second. I might buy the real estate, I'll rent it to you, I'll give you a really good rent rate. I'll defer the rent for a while." All those things they'll do that because they know it fits in with their tax planning. And they're going to get a huge benefit, they're in the highest tax bracket. So every dollar of deduction is worth over 37 cents to them in some cases, over 50 cents to them. So they may just be glad, "Hey, I'm putting my cash out there to play and it's going to save me a whole bunch of money."
Tax Planning: The presentation emphasizes the differences in tax treatment among these income types and suggests that individuals should aim to earn income in the categories with more favorable tax treatment. It highlights that many wealthy individuals primarily derive their income from capital gains and rental income to take advantage of lower tax rates.
Conclusion: The speaker concludes by suggesting that understanding the tax treatment of different income sources is crucial for effective tax planning. He encourages viewers to subscribe to his channel for more in-depth discussions on these topics.
I know I just threw a lot at you. There's a lot of content on this channel. Please subscribe, like us. And if you like this type of information, please share it."
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https://www.youtube.com/watch?v=YaGutYbwBE8
Strategy 1: Depreciation and Recapture
Strategy 2: 121 Exclusion
Strategy 3: 1031 Exchange
Throughout the video, Toby encourages viewers to explore these strategies as legitimate ways to minimize or eliminate capital gains taxes legally. He also invites them to subscribe to his channel for more valuable tax-related content and welcomes suggestions for future topics. This comprehensive summary captures the key points discussed in the video, providing a clear understanding of these tax-saving strategies in real estate transactions.
Hey, guys. Toby Mathis here. And today, we're going to go over a pretty interesting topic, which is how to pay 0% on capital gains when you sell a property. It's going to surprise some of you. But there are actually three ways, three ways where you can just avoid paying any sort of tax on this. There are two of them that are permanent. One of them that's going to require some elbow grease in the future. But let me go over these, and then specifically, I'm going to talk about real estate.
So when I'm selling real estate and I don't want to pay any capital gains on it, we're not talking about recapture. We're not talking about some of these other secondary items, although it is possible to push those out too. I'm going to specifically talk about capital gains and on a couple of different types of properties. So let's dive in.
Number one, when you own an investment property, you have the right to do what's called depreciation. Here's the funny thing is you may take depreciation, but you must recapture it when you sell. And this is not considered capital gain income. It's part of the gain, but it is recaptured on recaptured depreciation. And so what we're grabbing here is I took a deduction. Let's say that you bought a property. Let's say it's a single-family home for $200,000 and your land is $50,000. So you have $150,000 of depreciable basis for the structure, and you're going to write that off over 27 and a half years. Or if you do a cost seg, you'll be five, seven, 15, and 27 and a half years of, you know, what that is? The point is, is that you're taking a deduction as you go along because that property is going to have to be replaced every 27 and a half years. Right. Like the IRS says, it has a useful life, and you get to take a deduction over it. So that's depreciation.
The IRS says you can write that off, and you can use that to offset any rents that you bring in, for example. So we see this a lot of times when people have an investment property, and they might use it as a vacation home periodically, and they'll just be like, I'm not going to write it off. Well, here's the problem you MUST recapture. So if you haven't been taking depreciation under those circumstances, you can be in for a nasty surprise.
But that is not considered capital gains. What we're really looking at on capital gains is you think of selling your house, right? I wasn't using it as an investment property. I don't have any recapture. It's the difference between my basis and what I sell it for. You can adjust that basis by adding improvements and things like that, but at the end of the day, I'm going to be paying something called capital gains, most likely long-term capital gains on that income. And here are two options when you're doing that, when you sell your house.
Number one is you have something called a 121 exclusion, which allows you to write off up to $250,000 of capital gains if you're single or $500,000 of capital gains if you're married. So it's this kind of cool thing where, hey, I can own a house or say I bought a house for $200,000 and I'm living in it with my wife. And ten years later, we sell it for $400,000. We or two years could the last two years have been so crazy, but let's just say that's typical, and it's gone up in value there's $200,000 of gain when I sell, you know, subtract off some of the costs and things like that. Maybe I have improvements that I put on the house. But let's just say for the sake of argument that we're talking about $200,000 of capital gains. I would pay zero tax on that ever. No recapture, no worrying about, hey, do I have to invest in another property or anything? No, that's just a stone-cold. You don't have to pay any tax on it on your capital gains on that property because there's an exclusion.
And that exclusion says, I lived in it as my primary residence for two of the last five years. So 24 of the last 60 months I lived in it as my primary residence. It's in my name. It's my house, and voila, I magically get this big old exclusion that's called a 121 exclusion. And people are very aware of it nowadays because the real estate agents are, hey, we've seen appreciation in real property like crazy. And so they all have to be pretty much up on this. Otherwise, their clients are going to be impossibly surprised to pay tax on something that they wouldn't. Almost all accountants know that this is out there. It's not a hidden code provision. But you will still want to make sure that you're taking it. And so, hey, I never have to pay tax on that. It doesn't matter whether I go buy another property; it just means I never have to pay tax on it. The other way you never have to pay tax on it is, let's say, a similar situation except instead of a whole bunch of gain. Maybe I'm a retiree, and I sell my house. I bought it for $200,000, and after years of doing some improvements and things like that on the property, let's just say that I have $50,000 gain, and I'm a retiree and a husband and wife, and they're making $40,000 a year. That $50,000 on top of it is going to more than likely be taxed at zero because the long-term capital gains rates have a 0% category, up to about 90 grand. You have to look at your tax rates every year, and you look at it and you say, all right, there's my long-term capital gains rates in my falling. Below that, you get your standard deduction, everything else, and you look at it going, wait a second, I am in the 0% long-term capital gains bracket. I do not have to pay any tax on it. You'll never have to pay a tax on that. And that's fantastic. So that is way number two. So we had the 121 exclusion, and we have, hey, if it's low enough, it's going to be taxed at zero anyway.
And I get into arguments with accountants all day long on this stuff year after year because I look at people, and they might be making 30, 40, 50, $60,000 a year, and they have unrealized long-term gains in the stock market. And I'm yelling at them, sell that. Get up to the point where it's still 0% tax bracket, you know, so maybe sell $20,000 of your stock and reset the basis and buy it right back. And their accountants lose their minds and they say something like the wash sale rule. And I'm like, No, that's the wash sale loss rule. You can do this on gain, and there's no reason not to. It's recognizing gain when your taxes zero or let's say that you have a business, let's say that we're in a a bad year and in a business where you're kicking down ordinary loss or you love investing in oil and gas and you get your income down to the nub, you could sell property and have capital gains and not pay any tax on it. And a lot of times people don't realize that if you're one of those people that gets yourself down to the 0% tax bracket, I'm just telling you, it's okay to have $90,000 around $90,000 where the long-term capital gains, if you're married, cut that in half. If you're single. But you could have that, and you're going to pay a 0% tax on it.
So, yes, you could have income and still be at zero if it's capital gains.
And by the way, things like dividends on qualified companies, qualified dividends, they are also taxed as long-term capital gains. So they're at zero. So I always look at those folks are, my gosh, bless it. Like there's there's so much cool stuff here. There's a 0% bracket, and you'll never have to worry about doing anything. You don't have to reinvest it. You don't have to do anything. You just get free money. It's non-tax money. So you have 0% capital gains on your real estate. You never have to worry about it ever again.
Now, the third way is the most common one that you hear about, and that's by buying more real estate. It's called a 1031 exchange, and it's only real estate. Now, can we do this with there's no other types of assets, but if you sell an investment property and you buy more investment property and there are some rules on this, there's a time frame, 180 days, you have to identify replacement properties. You can you can do multiple properties, but not more than 200% of the value of the house of you letting go. Like, there's there's there's some rules that you have to follow. But here's the gist. You don't have to pay tax on it. You don't have to pay tax on the capital gains, nor do you have to pay tax on the recapture slows to two things are actually pretty big.
So you know go back to the situation where you have a primary residence that you lived in two of the last five years. But let's say that you rented it for one year before you sold it. Well, now you're going to have depreciation, recapture if you want to avoid it, you're going to have to actually marry the 121 with the 1031 exchange, which you can do.
The IRS tells us exactly how to do it, steps up the basis for that capital gain exclusion, and then you can offset and avoid having recapture on the depreciation, which might be a good idea, especially if you did a cost seg and you used it to offset other other passive income on something else if you're doing investments. But it's a fantastic tool to avoid the payment of tax.
So that 1031 exchange becomes your friend if you're a real estate investor. And all I have to do is keep buying more real estate of equal or greater value. I can't have, but I can't get a bunch of cash when I buy these properties. So I can't just go out and create a situation where I'm walking over the bunch of cash and not pay tax on it. I'm investing the money and I'm putting it into real estate and I'm going to continue to buy more real estate. And the really cool part here is that at the end of the day, as long as you do not sell in a taxable transaction, any of those properties. So as long as you're always 1031, eventually you pass away, your basis on those property steps up to the fair market value. On the day that you passed away, what does that mean? It means that for tax purposes, your basis is now the fair market value of the day that you passed, which means if you're heirs sell it, they pay no tax because it's that same value.
So what happened to all the capital gains and the depreciation you've been rolling forward? So a you know, 30 years ago I bought my first property at $200,000 and it went up to four. I bought a couple more. Those went up to $300,000 each. I sold those and bought five properties. Those went up to $400,000 each. And I had a $2 million portfolio. I sold those and bought some more. And now I have this portfolio of two and a half million dollars and I've never paid tax in any of the game.
And all I do is I pass away. And now if my heirs sell that two and a half million dollars for the property, you know what? My taxes or their taxes? Zero, right? I've never had to pay tax on that. So I just showed you three ways that you could never pay capital gains on real estate. I know there's tons of other cool things that the tax code gives us, but those are the three big main ones that I wanted to point out. And if you're catching that bug and realizing, wait a second, there's lots of cool stuff in the tax code, I want to learn more. Don't worry, I got you covered just like it. Subscribe this channel. I'm always putting out content like this, and if you think that this would benefit anybody else, by all means share it. And then, even more importantly, if you want me to cover other topics, put them down in the in the comments, I'll read them. And if it looks cool, I'll cut a video on whatever the topic is you are. You designate. Thanks, guys.