Money Rehab with Nicole Lapin - Tax Loopholes That Help You Keep More $$ From a Real Estate Sale

Episode Date: May 16, 2024

If you’re selling a property, you might have an awesome payday… but those gains could be erased by taxes. Thankfully, there are perfectly legal loopholes to avoid getting hit with a big tax bill. Nicole walks you through the loopholes you can use if you're selling your home, or an investment property.

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To get started, visit bofa.com slash newprosmedia. That's B-O-F-A dot com slash N-E-W pros, P-R-O-S, media. Bofa.com slash newprosmedia. I'm Nicole Lappin, the only financial expert you don't need a dictionary to understand. It's time for some money rehab. If you're selling a house, you have an opportunity to have an amazing payday, except those gains could be erased by taxes. But I have good news. There are perfectly legal loopholes to avoid getting hit with a big tax bill. Which loophole you use depends on whether you're selling your house or an investment property. To help you cover all of your bases, I want to walk you through both. But first,

let's talk about personal homes. If you sell your home for more than you bought it for, you'll need to pay capital gains taxes. There are two types of capital gains taxes, short-term and long-term. Short-term capital gains apply when you sell an investment before a year is up. Today, the rate is the same as ordinary income tax. If you're already a high-income earner, and if you're not, you will be soon, that ordinary income tax rate adds up to a lot. The top federal tax rate right now is 37%, which could be a big blow to the profit from the sale of your house.

Long-term capital gains, on the other hand, are taxes you pay on investments you hang on to for a year or longer. The tax rate for those gains is much lower than short-term capital gains. They are 20% for the highest earners and 0% for the lowest earners. So if we have to pay capital gains taxes, we want to pay long-term capital gains taxes. But there's another layer to this when we're talking about real estate. So to recap, if the property you're selling has been your primary residence for less than a year and you sell it, you'll be hit with short-term capital gains taxes. Boo. If you've lived in the house for longer than one year, but less than two, then you have

long-term capital gains taxes. Better than short-term cap gains, but still not the best. The best case scenario is actually when you've lived in the house for at least two of the last five years. And no, those two years don't have to be consecutive. If that's the case, then you don't have to be consecutive. If that's the case, then you don't have to pay capital gains tax on the first $250,000 of profit from the sale of your house if you're single, or if you're married, you don't have to pay capital gains tax on the first $500,000 of the profit of your sale. If you made more than that, well, first of all, congrats. Second of all, you do have to pay long-term capital gains taxes on all the remaining profit.

But still, long-term capital gains taxes is not that bad. So let's put your residence aside for a sec and imagine we're talking about an investment property. Similarly to selling a residential home, if you sell an investment property for a profit, you're going to be hit with cap gains taxes on what you earn. But you can't use the argument that you've lived in an investment property for two of the last five years because, well, it's an investment property and by nature, it's not your primary residence. That is where a 1031 exchange comes in. A 1031 exchange does not sound sexy, I will not lie.

But do not let this name fool you. It is another beautiful tax loophole that saves you from a big tax bill. And honestly, what is sexier than that? I'll wait. Like the name suggests, this money move is an exchange where instead of selling an investment property for cash, you essentially exchange it for a new property of equal or greater value. This move saves you from having to pay capital gains taxes on the cash that you make from

the sale because after the sale, you're not left with cash. You're left with a new and improved property. Pro real estate investors will keep doing this and doing this over and over again, exchanging properties until they're in a lower tax bracket or when tax laws are more favorable, and then perhaps they'll sell that property for cash. This is a great move for real estate investors because like I said a zillion times so far today, if a real estate investor just sells their property outright, they would owe up to 20% in cap gains taxes on that profit. But by skipping that tax bill, you get more money to reinvest than you would have had without doing the exchange. But unfortunately, you can't just use this loophole

to get yourself a dope new home. To use this hack, we have to be talking about three things. Number one, investment properties only. Both the house you're selling and the house you're buying must be for investment or business use, not a personal home. Number two, the right timeline. You need to complete the exchange within 180 days of selling the original properties, so you can't be sluggish on this. And number three, the exchange has to be direct without cash or non-like property involved. Let's double click on this one. You might be wondering what it actually looks like to exchange one property for another and not pay in cash. If you're buying a new investment property from seller Bob, you can't just say, hey, thanks, Bob. I'm going to buy your property and give you zero dollars, but you can have the property that I'm selling if you want it. Yeah, that doesn't work.

Of course, the seller does need to get paid for the property that you're buying. So what you do is when you sell the property that you're exchanging, the money from that sale needs to go into a third party escrow account. That money cannot pass go. It cannot pass through your bank account or this whole loophole falls apart. The rules are really strict here, but if you can check those three boxes, you can essentially give yourself a bigger budget to invest in real estate because you can take what you would have needed to put aside for your cap gains bill and reinvest that into your new, bigger, better property. And now might be a good time to look around, according to the chief economist at Zillow. Here's what she had to say about it.

There is a major fundamental shift in housing from pre-pandemic to now, right? And a lot of ways to think about the why of that is that low mortgage rates really cause insensational demand. And we harvested inventory down to such low levels. It's really hard to imagine like where all that new supply would come from because buyers would also be ready. Remember if mortgage rates came back up to actually return inventory up and inventory is just like the pool of homes are available at one time, right? So inventory remains very low, meaning kind of on net housing is more competitive than it used to be. That's why homes are still selling at 13 days and we expect 10, you know, moving forward. Pre-pandemic, you would have a couple of weeks, you know, you'd be able to make more of that decision. So that means on net, prices are still

coming in above that list price more often than pre-pandemic. For today's tip, you can take straight to the bank. If you do attend 31 exchange, you're going to need to pay really close attention to which closing costs you can use exchange funds to cover. The IRS says you can pay for closing costs from the exchange funds so long as those closing costs are normal transaction costs. This is in contrast to non-exchange expenses. And what is a normal transaction cost versus a non-exchange expense is not super intuitive. So for example, title insurance fees can be paid from exchange funds, but property liability insurance cannot. So when it comes

to 1031 exchanges, you're going to need to read the fine print in order to reap the rewards. Money Rehab is a production of Money News Network. I'm your host, Nicole Lappin. Money Rehab's executive producer is Morgan Levoy. Our researcher is Emily Holmes. Do you need some money rehab? And let's be honest, we all do. So email us your money questions, moneyrehab at moneynewsnetwork.com to potentially have your questions answered on the show or even have a one-on-one intervention with me. And follow us on Instagram at moneynews and TikTok at moneynewsnetwork for exclusive video content.

And lastly, thank you. No, seriously, thank you. Thank you for listening and for investing in yourself, which is the most important investment you can make.