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Santa Cruz properties have long been among the most sought-after investments in California. The market here presents many benefits to investing in rental properties, such as the possibility of tax benefits, steady rental income, long-term property appreciation, and the option to deduct losses from taxes. But when it comes time to sell, the US federal government's revenue department, the Internal Revenue Service (IRS) will try to make you pay for those perks by taxing your capital gains.
The dynamic nature of the real estate market necessitates savvy investors to identify ways to maximize their tax strategies and boost their bottom lines. Irrespective of location, whether you are considering Los Gatos homes for sale, Soquel, CA homes for sale, or investing in a single-family rental property in Santa Cruz, understanding the nuances of capital gains taxes is crucial for making informed decisions. You can (within the boundaries of the law) use some tactics to reduce, postpone, or not pay these taxes at all. However, before we discuss how to avoid paying capital gains tax on real estate, let us first understand these taxes.
What are Capital gains on Rental Property?
Capital gains mean you earned more when you sold an asset than when the amount you paid for it. It is determined by subtracting the buying price from an asset's selling price. In rental properties, capital gain real estate tax is the tax deducted from your profits when you sell a rental property at a higher price than what you initially paid. The size of this tax will depend on various factors, such as:
- The length of time you have owned the property
- Expenses and other legally recognized/justifiable deductions during ownership
- The existing lax laws governing real estate transactions The federal government categorizes capital gains taxes on real estate into short-term and long-term gains.
Short capital gains on rental property
Short-term capital gain will be realized when you sell your rental property within the first year of acquisition. In most cases, this is the case for a real estate investor who uses the fix-and-flip strategy. The short-term capital gains taxes on rental properties in Santa Cruz generally mirror the structure of a regular income. They are progressive, ranging from 10% to 37%.
The Short-term Rates for 2024 are:
0% Rate:
- Single: Up to $47,025
- Married Filing Separately: Up to $47,025
- Head of Household: Up to $63,000
- Married Filing Jointly: Up to $94,050
15% Rate:
- Single: $47,026 to $518,900
- Married Filing Separately: $47,026 to $291,850
- Head of Household: $63,001 to $551,350
- Married Filing Jointly: $94,051 to $583,750
20% Rate:
- Single: Over $518,900
- Married Filing Separately: Over $291,850
- Head of Household: Over $551,350
- Married Filing Jointly: Over $583,750
Long-term capital gains on rental property
If you buy and hold the rental property for at least 12 months, the IRS will levy long-term capital gains taxes instead. Depending on the tax band your income is in, you may have to pay 0%, 15%, or 20% in taxes on long-term capital gains.
The Long-term rates for 2024 are:
0% Rate:
- Single: Up to $47,025
- Married Filing Jointly: Up to $94,050
15% Rate:
- Single: $47,026 to $518,900
- Married Filing Jointly: $94,051 to $583,750
- 20% Rate:
- Single: Over $518,900
- Married Filing Jointly: Over $583,750
How to Avoid Capital Gains Tax on Rental Property
There are several ways to reduce or even avoid capital gains tax when selling rental property. Nonetheless, talking to a reliable real estate agent and learning their perspective before implementing these plans is crucial.
1031 Exchange
Thanks to 26 U.S.C. § 1031 (the Internal Revenue Code Section 1031), commonly called Like-Kind Exchanges, an investor can delay paying capital gains tax on their rental property until they plan to cash it out. It can be excellent news for rental property investors in Santa Cruz who are always seeking new investments.
With the 'Like-Kind Exchanges,' you can sell your rental property, acquire a property of a similar nature, and delay your tax payments. You have the flexibility to carry out 1031 exchanges over and over.
A more complex strategy known as a deferred exchange allows you to dispose of the property and keep the proceeds in trust until you can obtain another (many other) replacement rentals of a similar kind.
In this scenario, a like-kind refers to another property for rental only. One cannot, for instance, Section 1031, trade a rental property for a brand-new vacation house. The primary requirement is that the property should be used for rentals and make income. You must find a replacement property or properties within 45 days after the sale date and close on them within 180 days. If your tax return is due before the end of these 180 days, you need to close sooner.
Exclusion from Capital Gains Tax in Opportunity Zones
Like a 1031 Like-Kind Exchange, you may delay paying capital gains tax under the Opportunity Zone legislation if you reinvest the money within the first 180 days of the selling date.
Goal: The Tax Cuts and Jobs Act of 2017 (TCJA) created Opportunity Zones (OZ) throughout the United States. This program aims to help economically struggling areas recover and thrive. The zones are located in sparsely populated urban regions and increasingly rural ones that have witnessed minimal economic transformation in their surrounding communities and industrial districts.
An opportunity zone rental-real-estate investor can delay paying capital gains taxes for a short period. The only thing that matters is that the money from the sale of the property goes into an opportunity zone fund. Here are some benefits:
- Not only will your gains be reduced by an impressive 10% in just five years, but you'll also enjoy an additional 5% reduction in seven years. The best part is that you can defer these gains for up to nine years, giving you even more flexibility and control over your investments.
- The possibility of obtaining capital gains tax-free is the most alluring aspect of purchasing a rental property in an Opportunity Zone. Investments held for ten years or more within Opportunity Zones are exempt from federal income tax on any property value surge. If you are one of those Santa Cruz real estate investors planning to hold on over the long haul, this provision can greatly improve your ROI.
Take Advantage of IRS Section 121: Convert the Rental Property into Your Primary Residence
The Target Population is anyone who can make a rental house their main home. It comes with the option to accumulate capital gains up to $500,000 tax-freely.
Selling your primary residence has more positive tax implications than selling rental properties. You can deduct up to $250,000 in earnings from selling your primary house if you are single and up to $0.5 million if you have a spouse and are filing jointly, according to IRS Section 121. However, you are only eligible to sell the property and benefit from these exemptions provided that you have called it your primary residence for at least two of the five years before the sale. The years don't need to be consecutive when used as a personal dwelling. This is why some investors decide to live in their rental houses full-time, converting them into primary residences.
The length of time the property was rented out rather than lived in determines the amount that may be deducted. Furthermore, the part of the gain that might have been deducted for depreciation cannot be excluded by the taxpayer. This is called depreciation recapture. A 25 percent recapture rate applies to the amount that was previously deducted for depreciation.
Tax-Loss Harvesting
One way to lower your taxable income on capital gains is to utilize investment losses as a tax offset, a practice called tax harvesting or tax-loss harvesting.
- Identify Losses: You identify investments that have decreased in value since you bought them.
- Sell at a Loss: You sell these underperforming investments to realize a loss.
- Offset Gains: These realized losses can be used to offset any capital gains you've made from selling other investments that have increased in value.
Reduce your taxable income and the amount of capital gains tax you owe by offsetting your gains with losses.
- Gains: Let's assume you reaped $50,000 on the sale of a rental property.
- Losses: In the same year, you sell stocks that have lost $100,000 in value.
- Offset: You can use the $50,000 loss from the stocks to balance out the $100,000 gain from the property.
You will not be required to pay capital gains tax on the sale of the property since your taxable gain will be zero.
Most Important Things:
- Different Forms of Profit and Loss: According to the IRS, you have the option to match long-term losses with long-term gains. Similarly, short-term losses can only be matched with short-term gains.
- Carryover: The term "carryover" refers to using past losses to offset future profits if your losses are greater than your gains.
It's crucial to follow IRS regulations and consider getting an expert to ensure that tax-loss harvesting is done properly so you can reduce taxes.
Purchase the Rental Property using your retirement account
There's a rising interest in how to use a 401k to buy a house. Many investors are exploring using their retirement savings to invest in rental properties through tax-deferred accounts like a Roth IRA, 401(k), or Individual Retirement Account (IRA).
- A Roth IRA is an account in which you pay taxes on your contributions but avoid paying taxes on future withdrawals. Watch your money grow without the burden of taxes, and when it comes time to withdraw, you can be confident that you will not owe any taxes as long as you follow the rules and regulations.
- A 401(k) plan is a government run retirement savings account established under Section 401(k) of the United States Internal Revenue Code. You contribute a percentage of your paycheck to this account; sometimes, your employer matches your contributions. It is a method to save for retirement using funds deducted straight from your paychecks.
- Anybody with a paycheck can use an IRA (individual retirement account) to make long-term, tax-advantaged savings for future needs.
Then, until the investor starts withdrawing their money, the rental income and capital gains can accrue tax-free. When you submit your taxes, you may deduct a portion of your money into an IRA. Your investment grows free of taxes until you withdraw it. Plus, you should be at a lower tax rate when you retire, meaning you'll pay fewer taxes on the money you take out.
Paul Burrowes, CRS, CCEC, SFR, NHCP, LHC, REALTOR® Licensed REALTOR® with over 15 years of experience and expertise. Commits to being on time and transparent. Acts as your consultant to ensure you make the best decisions to fit your transaction at every step in the process. Negotiates towards a low stress, win-win outcome. Handles all the details for you, ensuring the hundreds of steps in your real estate transaction go smoothly. Proudly serving Silicon Valley, Santa Cruz, Monterey, and Santa Clara Counties! | DRE# 01955563 | (831) 295-5130 | paul@burrowes.com | About Santa Cruz and Northern California Real Estate
Local 1031 and tax deferment specialists
Carl F Worden III
Author, Educator, Tax Deferral Consultant
Tax Deferral Strategies LLC
www.DeferTax.com
www.StartAnExchange.com
3031 Tisch Way Suite 901
San Jose, CA. 95128
TF: 877-TAX-STRATEGY (877-829-7872)
PH: 408-261-2275
Ron Ricard
Account Executive, VP
IPX1031
ron.ricard@sis.ipx1031.com
(408) 483-1031
Work | (877) 747-7875
www.ipx1031.com/ricard
Thomas Foster, Esq., President
Nationwide 1031 Exchange Intermediary Services
331 Soquel Avenue, Suite 100
Santa Cruz, CA 95062
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