4 of 4 on Capital Gains | Maximizing Profit and Minimizing Taxes: Advanced Real Estate Strategies
In our previous posts, we explored how to transition your primary residence into a rental property and build a real estate portfolio; AKA 'The Plan'. This post is a bit longer, but well worth the read because we are putting some very critical pieces together.
Here I'm going to lay out a few strategies to help you keep your hard-earned money.
Let's get into it.
It’s your money, keep it:
Now that you understand the basic plan, let's discuss how to keep your equity and appreciation as funds for your retirement. Here are the Strategies to Maximize Your Profit:
2-in-5 rule (IRS Section 121 Exclusion)
1031 exchange
Future refinances
Should you need to sell one of your properties, there are two strategies to protect yourself from paying capital gains taxes and keeping more money in your pocket. The first is to live in the home for at least 2 out of any 5-year period. The second is to use a 1031 exchange to sell an investment property, buy another investment, and defer your taxes. Just know you have to put all your profit from your sale immediately into the new investment. Meaning, you can't keep a portion of the proceeds.
The 2-in-5 rule:
The capital gains tax differs between investment properties and primary residences. The 2-in-5 rule stipulates that you must live in a property for two out of the last five years for it to qualify as your primary residence. Meeting this requirement allows you to enjoy certain tax deductions and avoid the same level of taxation applied to investment properties.
Capital gains tax on real estate is a fee imposed on the profits made from the sale of a property. It is calculated based on the difference between the purchase price and the selling price of the asset.
Now, the amount owed depends on various factors, including the duration of property ownership, the cost of ownership, income tax bracket, tax filing status, and the holding period. Long-term capital gains (properties owned for over a year) are taxed at rates of 0%, 15%, or 20% based on taxable income and filing status. Short-term gains (properties owned for a year or less) are taxed at ordinary income rates, which can reach as high as 37%.
By meeting the 2-in-5 requirements, you can qualify for significant tax benefits. If you decide to sell, you can enjoy tax-free profits of up to $250,000 (or $500,000 if married) as long as you meet the criteria. That's pretty easy to do, and a lot of people use that to their advantage when they are trading up for a bigger home in a nicer area.
Not everyone wants to be a Landlord, or build a portfolio:
You could hold onto the property as a rental for 2.5 to 3 years and then sell it before the two-out-of-the-last-five-year window changes. This approach allows your property to continue appreciating in value while someone else pays the mortgage for a short time. By timing your sale strategically, you can benefit from both rental income, and appreciation, and avoid capital gains taxes. This is a massive strategy.
What about 1031 exchanges?
Another option would be a 1031 exchange. But you don’t get the money. It has to go into another investment. A 1031 exchange allows you to defer paying capital gains taxes on an investment property when it is sold, as long as another like-kind property, an investment.
Now, you can’t do this with a primary residence, it has to be an investment. The tax code doesn't state precisely how long you must hold the property for rental purposes, most tax professionals and CPAs recommend that you rent the property at fair market value for at least two years to establish it as a bona fide investment asset.
The IRS is clear on two points:
First, merely declaring your house is a rental property isn't enough.
Second, you can't live in your home at all while it's a rental property, and you must rent it out.
To execute a 1031 exchange, you must follow specific rules:
The replacement property must be identified within 45 days of the sale.
The replacement property must be purchased within 180 days.
Both properties must be used for investment or business purposes.
So be sure you have a clear paper trail… and a CPA. You’ll also need to pay for a 1031 facilitator. Best advice here is to also have the new acquisition property identified before you start this process. It can be complicated and feel convoluted if you’ve never done it before, so be sure to have your team in place before you attempt to move forward.
What’s the Goal?
That said, the goal isn’t to sell. The goal is to buy, get debt service through the increase in local rents, and then buy again keeping your departing residences along the way.
For the sake of argument, let's say you acquire 3 rentals, you’ve worked this plan for the last 10 years, you got a late start, and you’re 55 and want to “retire” - what do you do?
Well, over the last 10 years, your first home has likely got up significantly in value along with local rents. Let's say you bought a townhome for 750,000. Would it be crazy to think that over the last 10 years, your 750,000 purchase is now worth 1.500,000? No, not at all crazy at all. Historically homes double in value over a 10-year period.
So here’s what you do.
Don't Sell—Perform a Cash-Out Refinance. (maybe)
First, have you been charging market rates for rent? The reason I ask is you need to have debt coverage. You want to be sure this isn’t costing you out of pocket. So if now rents are 7,500/ month, you’d want your total payment on the refinance to land somewhere around 6000 a month. That gives you a 20% buffer, aka Cashflow, and ensures your debt service is covered. You’ll most likely have to pay a much higher interest rate when you refinance because it’s no longer your primary residence - BUT WHO CARES??!!
The debt is being serviced by your renters. Again, by ensuring that rental income is within 20% of the payment, you cover the debt and still have a little cash flow for repairs - even if the interest rate is higher than it was. Now you can create positive cash flow while still accessing the equity in your property.
Most importantly, a cash-out refinance is NOT a taxable event; it is a loan, meaning the money you pull out is yours, tax-free. This is the big secret big time investors know that other people don't. They NEVER plan to sell. They can take refinance loans on property 'until-the-cows-come-home' and never pay any taxes. It's about debt service and letting someone else pay the bill for you.
That’s the point.
That’s what we are working for here. Tax-free money that is serviced by someone else.
Now, it wont change your cost basis, BUT, it could be the strategy you are looking for. And, if you’ve read my blog on end-of-life planning, you might remember that holding your property in a trust and passing it along to the next beneficiary when you pass away DOES change the cost basis and helps them avoid a significant tax liability.
That said, in this scenario, because you own a few other properties, you can do this every 3 years or so.
Let me ask you this, do you think $500,000 cash every 3 years or so would impact you and your loved one's lifestyle over your retirement? Would it be a good way to supplement your pension and stock portfolio?
I think it could. I also think this is the easiest way for anyone to build significant wealth with the least amount of effort. Are there things you have to give up to do it? Yes. But would that be so terrible?
Why this is Powerful.
There are 2 basic reasons this is so powerful. They all have to do with you making your initial purchase as a primary residence and NOT an investment.
First, purchasing as an investment would require you to put 25-30% down. But with a primary residence, you can put a lot less down.
Second, the interest rate an investor pays is substantially higher than someone purchasing their primary residence. And, when you move into your new place, your interest rate on your departing residence won’t change. That said, you should tell your homeowners insurance that it’s now a rental, and that could increase your premium a bit, but it shouldn’t be substantial.
What Happens Next—A Simple Plan:
To build wealth through real estate, follow this simple plan:
Purchase your home as your primary residence.
Refinance when interest rates drop.
Continue advancing in your career, earning promotions and raises, and save money for your next home.
Resist the temptation to increase your spending as your income grows. Embrace the joy of saving and prioritize saving for your next home just as fervently as you did for your first.
Aim to acquire 3-5 homes within the best 10 years of your working life to accelerate your wealth and secure a financially abundant retirement.
Do you have to refinance? No.
Can you live off the cash flow that’s been generated over the last 10 years and still live your life the way you want to? Yes, maybe. Probably.
Maybe just holding the properties with a low mortgage payment and receiving the difference between the mortgage and rental rate could be enough. If so that’s also amazing!
Either way, you are winning.
Here’s the deal:
I want to see you win. Reach out to me and we can brainstorm some options to get you started. I know not everyone wants to be a landlord. I think too many people worry about leaky toilets and phone calls in the middle of the night versus looking at the simple opportunity to build wealth through real estate over time. It doesn’t have to be complicated, and it wont be overnight. This is a very simple plan that requires very little to get started - you just have to buy your first place, and then keep it.
Reach out. Lets chat. I can share some other ideas, tips, and tricks to make it really easy and convenient for you to ensure your success.
If you're making a move, reach out, and lets chat. Happy to brainstorm and come up with a solution that gets you a tangible and actionable plan that fits your unique situation.
Best,
Justin H Gazabat
Broker | PNW, Seattle, Ballard, East Side
Your Friendly Seattle Neighborhood Real Estate Professional.
www.JustinGazabat.com
P.S. I sincerely appreciate your continued trust and generous support of me and my business. It truly means the world to me when you think to connect me to your friends, family, and co-workers.
P.P.S. If anyone in your social or work circles is considering a move, just send an intro text or email with their best contact info, make sure everyone is CC’d and I’ll take care of the rest! I promise to take great care of them, serve them well, make you look really good in the process. Plus help them get great results! Referrals are crucial to our business, and we genuinely value the opportunity to serve you and your network.
