There are many reasons to purchase investment property. While this type of investment can come with large upfront costs, more work, and higher risk levels, there is also the real opportunity to experience some of the highest possible returns.
But one of the downsides to owning investment property is the potential for a large tax burden when selling the property. This tax burden, depending on how much you have profited from the sale, could be tens of thousands of dollars; it could even reach into hundreds of thousands when selling a multi-million-dollar property.
Fortunately, there are ways to reduce your tax burden. What’s more, you can take the money saved through these strategies and buy mortgage notes, allowing you to expand and diversify your overall portfolio.
Note: This article is for general information only and should not be considered tax advice. Tax laws constantly change, so always speak with a qualified expert before making any decisions on selling investment properties.
Avoid a Big Bill: How to Reduce or Defer Your Tax Burden When Selling an Investment Property
Track and Utilize Your Losses
Claiming losses on the property can be the single-most effective way to reduce or entirely eliminate your tax burden. Throughout the year, you likely spent a lot of money on updates, repairs, and revisions to the home. When preparing to sell your investment property, you may have purchased new appliances, upgraded the windows, or paid for landscaping services. All of these costs can help reduce the amount of taxes you owe when selling the home.
Of course, it’s crucial that you actually have a tax loss, as it would be immoral and illegal to simply make up financial losses. However, you should not let any real expenses go unused as part of your tax filings.
Use an Installment Sales Trust
This method of deferring taxes on a property’s sale is little known compared to a 1031 Exchange, but it has many advantages. Unlike its cousin there is no time limit or “like kind” property requirements for the transactions. You can effectively time the market and “sell high and buy low” by investing appropriately. You can also buy other types of assets like stocks, precious metals, or other products. You should use a qualified counselor when setting up a transaction, but your savings can be significant.
Use a 1031 Exchange
The 1031 rule is a simply a way to move money from the sale of an investment property immediately into another property without paying gains taxes. Using this tax-code option, you can sell an investment property and swiftly purchase a new investment property, essentially changing the form of the investment without actually cashing out your finances.
This is a useful option for investors who want to improve their property portfolio by eliminating less-than-profitable holdings. For example, you can sell a property that is not making money and purchase one that (hopefully) will. Talk with a qualified tax expert to learn more about the 1031 process.
Move Into Your Investment Property
There are more tax benefits to selling your primary residence than selling your investment properties, so you could utilize the long-term strategy of turning an investment into your home. This allows you to avoid the tax hit of capital gains, and also gives you a place to live!
But like we said, this is a long-term strategy. In order to file the sale as a primary residence, you will likely have to have owned the home for at least five years and lived in it for at least two of those five.
Roll the Proceeds into a Retirement Account
In many ways, the national tax code is designed to encourage people to invest in long-term retirement strategies. Here is just one example: If you sell a property and place the earnings directly into your checking account, they will be subject to capital gains taxation. However, if you roll them directly into a retirement account, such as a traditional IRA, 401(k), or Roth IRA, you can significantly reduce or entirely eliminate your tax burden. Roth accounts in particular are useful for avoiding taxes, as they allow for tax-free growth.
The only issue with this strategy is that your money is locked into the account until you reach a certain age. You can take money out of a tax-sheltered retirement account, but you are often hit with an even larger tax burden. So, you should only use this tax-avoiding strategy if you don’t plan on using the money for many years.
Use the Proceeds to Buy Mortgage Notes?
With a few of these tips, your money may be locked into a property or retirement account for a few years. But if you can gain access to this cash, you might consider using the tax-reduction proceeds to buy mortgage notes.
Owning mortgage notes basically means you are the owner of a mortgage loan; people will actually be paying you money instead of a bank. You can purchase mortgage notes from an individual note investor/broker, through a note brokerage, and real-estate investment trusts may also sell shares of mortgage notes. This is a good investment strategy that provides a basis of stability to your portfolio. The returns can be equal to or greater than owning a property and you avoid all of the ownership issues. They enable you to stay involved in the real estate market while enjoying steady, consistent returns, all with little risk.
Purchasing mortgage notes from an individual note investor that you know and trust has many advantages over buying them from brokerages and other sources. Many private investors/brokers only buy and sell notes that they would be happy to hold in their own portfolio. Thus, they are usually well underwritten and of higher quality than those sold by brokerages and other sources.