Capital gains are the money you earn from the sale of an asset minus the original cost and any fees. The government always expects you to pay taxes on capital gains, and there is no way to completely avoid them. One option is to delay the payment of those taxes until a later date.
Depending on the asset, you may have several ways to avoid capital gains taxes. Investments in real estate, for instance, have several options.
Short-Term vs. Long-Term Capital Gains
Whenever you hold an asset for less than one year, the Internal Revenue Service (IRS) classifies it as being short-term. Assets in this category have a higher tax rate when sold. Short-term gains are treated as ordinary income taxes, which can go as high as 37 percent.Long-term capital gains are taxed at a lower rate, which makes it worthwhile to hold those assets longer than one year. The IRS says the tax rates for those assets range from zero to 20 percent, but it depends on your tax-filing status. In 2023, singles or those married filing separately do not pay any capital gains taxes if they earn less than $44,625. A head of household can earn up to $59,750 and not owe any capital gains taxes. Married couples filing jointly can earn up to $89,250 without paying any taxes on capital gains.
Those who are single or head of household can earn from $41,676 to $459,750 and will have to pay 15 percent in capital gains taxes. Those who are married but file separately and earn from $41,676 to $258,600 will pay 15 percent. Married couples filing jointly and earning from $83,351 to $517,200 will also have to pay 15 percent in capital gains taxes. People earning more than these amounts will have to pay 20 percent in capital gains taxes.
Some Assets Have a Higher Capital Gains Tax Rate
Some assets are automatically assigned a higher capital gains tax rate. The IRS says that section 1202 qualified small-business stock can be taxed as high as 28 percent. If you hold it for more than five years, Investopedia reveals you will not owe any federal taxes on capital gains.Selling collectibles also face the same tax rate of 28 percent. Other items falling into the same tax category include household furnishings, precious metals, gems and jewelry, digital assets, stocks, bonds, your vehicle, timber grown on your home property, etc. Investopedia mentions that assets you create are excluded from capital gains taxes, and include patents, inventions, copyrights, literary or artistic compositions, drawings, photos, letters, etc.
Avoiding Capital Gains Taxes in Real Estate
You can expect to owe the federal capital gains tax when you sell real estate under certain conditions. AndersonAdvisors identifies these conditions as selling a second home after owning it for less than two years in a five-year period, which includes a vacation home, rental home, or investment home. You will also owe the gains tax if you have lived in a primary residence for less than two years out of five years.When selling your primary residence, the capital gains tax on home sales differs from selling a second home or rental property. You will have a tax exclusion on your home if you have lived in it more than two years. Investopedia says the exemption is $250,000 if you are single and $500,000 if you are married.
How to Sell Rental Property and Avoid Capital Gains Taxes
Selling rental property and getting the maximum profit from it can be difficult. Because market-timing is unassured, you should sell it when the market enables you to get the most from the sale, at least to your satisfaction. It is also necessary to buy and sell it within a retirement account. This arrangement lets you avoid capital gains taxes until you retire, but IRA Resources says there are some rules you must follow. When making withdrawals in retirement, you can enjoy a lower tax rate.Reinvest the Money in a New Property
After you sell a rental property, there are a couple of other ways to reduce or avoid the capital gains tax on real estate. By converting it to your primary residence and living in it for two out of the next five years, you avoid the tax by being able to take advantage of the $500,000 tax exclusion for couples or $250,000 for singles. At the same time, RoofStock says that you also must not claim any capital gains tax from other sales.Donate to Charity
Part of your strategic planning can include giving unneeded gains directly to charity. Your gift has to be transferred directly to the charity and not cashed out. A direct transfer helps you get a tax deduction for the donation and avoids capital gains taxes. Charitable donations cannot exceed 60 percent of your adjusted gross income.
Giving to charities can be especially useful in years when you have a larger than usual income, possibly from selling a business or getting a large bonus. You can also donate a required minimum distribution (RMD) if it puts you into a higher tax bracket. In that case, you can give several year’s worth of donations. If you cannot use itemized deductions yearly, this step could enable you to do so.
Create a Charitable Trust
Two kinds of trusts can enable you to pass some of your assets to your heirs and charitable organizations. Your donations can start during your lifetime and continue after you are gone. Nerdwallet says that a charitable remainder trust (CRT) is an irrevocable trust that lets you create a stream of income for your heirs for a designated period. When the time is up, the remainder of the assets pass to the charity of your choice. A charitable lead trust works in the opposite way.Because both of them are irrevocable trusts, you get a tax deduction. At the same time, you also benefit by avoiding any capital gains taxes.
Capital gains from the sale of assets can cost you, but having strategies in place can help you avoid taxable capital gains. Talk to an estate planning attorney to discover the best ways to keep more of your assets.
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