Finding silver linings in the cloud of capital gains tax
America started charging income tax in 1913 and started taxing capital gains in 1916 (with a top rate for both of seven percent). From what sources tell us, the President and Congress have their sights set on raising capital gains taxes, the income earned when you sell an asset for more than you paid.
The plan in Washington DC is to double the current capital gains tax on those with income over $1 million. The top rate now is around 20 percent, but they want to raise it to 39.6 percent plus a 3.8 percent Medicare surtax, making the top rate 43.4 percent.
Many investors are not thrilled about the dark cloud of higher taxes. But this cloud is lined with silver, and I’ll explain two ways to mine it out.
Silver Lining #1
As any real estate investor knows, there are seller’s markets and there are buyer’s markets. But in today’s market the stars are aligning for this to be the ideal year to either sell OR buy IF you can utilize creative financing with terms in your favor. It’s all being driven by the proposed increase in capital gains tax.
If you’re in the $1 million earning category and you own multiple properties, it seems logical (with prices as high as they are) that you should consider taking some profit off the table. Your rental properties have likely appreciated in value, so if you sell now, you’ll pay half as much in capital gains taxes compared to selling next year. But whether you make more than $1 million or less, could soon be losing equity should more properties flood the market and prices soften, it could be a good time to take money off the table by cashing in your equity.
When you offer seller financing to your buyer you can get money today (as a down payment from a well-qualified buyer) plus predictable long-term income to replace your rent checks. Another benefit is that you can eliminate landlord headaches like repairs and deadbeat tenants. If your buyer defaults, the house is your security for the loan.
But it’s also a great time to BUY because many landlords are gaining motivation to sell—especially hobbyist landlords who only own a handful of properties. If they get their asking price, they are by far the most likely candidates who are willing to carry the financing because the monthly payments will replace their rental income.
But there’s another layer of silver inside this cloud—and it’s even better than the first.
Silver Lining #2
You can spread your capital gains tax payments (on the current low rate) over the next fifteen years with no interest or penalties.
This technique is called the “installment sale method,” and it’s been around for years. Your capital gains taxes are paid overtime as you receive the payments. You can utilize the installment sale method whether you make over a million or less. Lately, I’ve chatted with 15 savvy real estate investor strategists, and all agree to do this BEFORE year’s end.
Let’s say you bought a property years ago for 100K and sold it for 250K, so you made 150K. Your capital gains tax on the 150K at today’s rate of 20 percent would be $30K. You could pay it all at once if you want to, but by using the installment sale method you could spread out the gain and pay taxes on $10K per year which means you’d pay the IRS $2K a year for fifteen years. You’d be paying today’s tax bill with tomorrow’s dollars (which are likely to shrink due to inflation). You can also be earning interest on that $30K (minus the $2K annual withdrawals) over years.
One sidenote: tax laws have historically locked in the rate for the installment sale method to the year you took the capital gain. Experts I’ve consulted with say it would be “unprecedented” for the current law to change, but it can’t be ruled out with 100 percent certainty.
When you calculate capital gains taxes you can also reap the benefits of depreciation on your property. (Find an accountant who has experience in rental property income.) Here’s a simple explanation of the three ways to depreciate:
- Regular long-term depreciation: Most residential rental property is depreciated at a rate of 3.636 percent each year for 27.5 years.
- Accelerated depreciation: This method allows greater depreciation expenses in the early years of the asset’s life.
- Personal property depreciation: This covers items that are sold along with the house such as appliances.
People mistakenly assume that all three types of depreciation must be figured in the year you sell the property. But it only needs to be applied in that tax year IF you use the accelerated depreciation or the personal property depreciation. The long-term depreciation allows you to spread it out as part of the installment sale method to continue to stretch-out your taxes.
The funny thing is that you’re claiming depreciation on something that has increased in value. That’s where “recapture” comes into play. It’s the process the IRS uses to collect taxes on the gain you’ve made from your income property and to recover the benefits you received by using depreciation to reduce your taxable income. Say you made $50K in profit on the sale of a property, and you took depreciation. However, the IRS says you took a tax advantage you didn’t need—you said its value depreciated, but it went up. You got the tax benefit, so the IRS recaptures that depreciation. Fortunately, you can spread that part of your recapture out over time just like your capital gain on the sale.
This is Decision Year
This is decision year for investors who want to buy properties from motivated sellers. It’s also decision year for anybody who owns a rental house and plans to someday sell the property. If they decide not to sell now, the property may go up in value, but the tax rate is doubled (for those in the million-dollar club). How many more years would you need to keep a property to make that math work?
Part of being an entrepreneur is to discover voids in the market and provide creative ways to fill those voids. There are some massive voids appearing now because of the proposed tax changes, which make it the perfect time for investors to buy and/or sell properties with creative financing.
Since 1980, Eddie Speed has dedicated his life to the note industry and to expanding the benefits of creative seller financing for both sellers and buyers. He teaches these techniques through NoteSchool, the training school he founded in the early 2000s. Eddie is also the owner and President of Colonial Funding Group LLC, which acquires, and trades real estate secured notes, and he’s a principal in several Private Capital funds that acquire bulk note portfolios. Eddie speaks at numerous real estate events every year across the country and has personally closed around 50,000 note deals.