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Navigating the Tax Maze When Selling Your Home

Season #2

Hey folks, remember when we last chatted about real estate a few episodes ago? I know, I know, taxes weren’t on the agenda then, but let’s delve into it now. Trust me, even some seasoned advisors seem to overlook this crucial aspect. So, sit tight and let's unravel this tax maze.

First off, let's dust off our tax code understanding. You might ask, "What makes my house qualify for capital gains exclusions, Leibel?" Well, you need to have lived in it as your primary residence for at least two of the past five years. Let me walk you through how it works.

Understanding Capital Gains

Suppose you bought a charming little place for $100,000 and eventually sold it for a neat $200,000. Your capital gain? That's the difference between your buying and selling prices, making it $100,000 in this case. Now, many folks would think they'd have to pay tax on that full $100,000, but that's where the tax code becomes your friend. It provides a sort of safe harbor, an exclusion that allows you to not count a certain sum as taxable income if you sell your primary residence (given that you meet the living criteria, of course).

If you're a lone ranger, this exclusion limit is $250,000. If you're hitched, it's even better - you can exclude up to $500,000. So, all that capital gain from selling your home up to these limits? They're safe from Uncle Sam.

Now, here's where the forward-thinking you comes into play. Keep an eye on how much your home has appreciated, and what taxes you might be liable for when you sell it. Sure, that $500,000 exclusion sounds like a truckload of money now, but 20 or 30 years down the road, it might be a different story.

Track Your Cost Basis!

The other player in this game is your property's cost basis, typically what you initially paid for your home. But, my friends, you can be smart and adjust this cost basis with capital improvements made to the property. Major renovations, new additions, floor replacements, boiler installations, and other considerable improvements can increase your cost basis. And higher cost basis equals lower recognized profit and hence, lesser tax. So, be diligent about tracking and documenting these improvements over your ownership period.

Selling an Investment Property

Investment properties, now, these beasts are a completely different game, aren't they?

Investment properties, unlike personal homes, are businesses, and just like any business, they have income, expenses, and yes, that pesky thing called depreciation. Assuming your tax preparer has been on the ball, they started depreciating your investment property from year one.

Let's use our favorite $100,000 property for this example. You can depreciate that value over approximately 27 years. During this period, the depreciation counts as a loss, an 'deduction' in tax parlance, even though no real money exits your pocket. This faux-expense can offset your revenue, reducing your taxable income.

Racking Up Paper Losses

This is another way the tax code encourages us to become landlords and real estate investors. The tax code, ladies and gentlemen, isn't some grueling document designed to make our lives harder - it's a playbook. It nudges us towards certain behaviors, like buying investment properties for that sweet, sweet depreciation benefit.

Now, let's dive a little deeper into the practicalities. Imagine your investment property rakes in $1,000 a month in rent, but you spend $500 on its maintenance. With depreciation in the picture, you might, on paper, end up showing a loss, even if you're earning real income.

Don't Let Depreciation Bite You On The Way Out...

But here's the catch. When you sell your investment property, the IRS will want you to recapture that depreciation. Every dollar of depreciation you claimed will need to be added back into your income, and guess what, it's taxable. And don't forget about those capital gains. Using our $100,000 property example, if you sell it for $200,000, you've got another $100,000 in capital gains to deal with.

Now, you may be thinking, "Hold on, Leibel, that sounds like a hefty tax bill!" You're right! It's like the IRS planted seeds, helped you grow a money tree, but now they want their share of the fruit. The moment you take your investment back, the government wants their incentive back.

Tips From The Tax Savvy

So, what do savvy investors do to avoid this hefty tax bill? They usually roll their investment into another piece of real estate, a strategy known as a 1031 exchange. This method allows them to avoid recognizing their gains as taxable income.

You might wonder why they don't just exit real estate, but the huge potential capital gains tax bill often dissuades them. Therefore, they continue to roll over their investments into new properties. Plus, banks are often willing to provide a mortgage on the new property, enabling a $200,000 investment to balloon into a $2 million one, and so forth.

Instead of selling, these investors borrow against their properties, utilizing the equity without triggering a taxable event. And here's the kicker - there are no taxes on debt. So yes, at some point, you're going to have to pay the taxman, but with a strategic approach, it might not be today.

Making the Most of Your Situation

Now, let's get to some practical advice for everyday folks like you and me.

When we talk about retirement, for many of us, our home is our biggest investment. As retirement nears, we might sell our home, downsize, and turn that into an asset that we live off of. But remember, this could potentially have tax consequences. How do we offset those, you might wonder?

Tax Loss Harvesting

Here's a strategy we've discussed a few times before - ordinary tax loss harvesting. If you have investments in a brokerage account and face a temporary loss, don't panic. Instead, "harvest" these losses. These paper losses can help offset the very real gains you get from your property sale, ultimately softening the blow on your tax return.

The key here is to figure out how to use your situation to your advantage. Let's call it the "lemonade from lemons" approach. Often, the difference between the wealthy and everyone else lies not in stepping over others, but in knowing how to use every situation to their advantage. Think about what tools and levers you have in your life that can be utilized in your favor.

Now, it's perfectly normal to not know everything about taxes, real estate, and investment strategies. Heck, if it wasn't for my 15-plus years of experience and exposure to knowledgeable individuals, I wouldn't know half of these things. But that's the beauty of our interconnected world.

These days, there are countless experts sharing their wisdom on social media. And it's free! Younger generations are using platforms like TikTok as search engines for knowledge. Whether you want to learn directly from these platforms, or you prefer folks like me to digest that information and relay it to you in a simpler format, the point is to stay curious.

You need to consistently ask yourself how to maximize your current situation. What you might think is a disadvantage could potentially be turned into an advantage with the right knowledge. So, dive into the wealth of information out there, connect with experts, and ask the right questions. You never know how a simple trick or tip could change your financial game.

Until next time, stay financially savvy, my friends. And remember, even when you're dealing with lemons, there's always a way to whip up some tasty lemonade.