0 capital gains tax if tax bracket is less than 15%??

Question

I'm far from the 15% tax bracket, but my tax bracket will drop drastically in retirement, so I'm wondering if the 0% capital gains tax will apply to real estate investors who sell real estate and are in the 15% or 10% tax brackets.

Dave Foster · Answer

@Brenda Whittaker, and to add to what @Taylor Brugna said, you can also deal with capital gains by leaving them in real estate but 1031ing into fractional or passive real estate investments.  They retain their tax deferred status but you still get to make income on the tax deferred dollars for life (then see death, the second best way to eliminate capital gains).

Another option is a periodic conversion from investment property into primary residence.  This at least gives you a prorated amount of the gain tax free.  And it's available every 2 years.

Brenda Whittaker · Answer

I cant sell my home.  I love it and it's perfect for me.  I want to unencumber it and live in it forever.

Thomas Rutkowski · Answer

Seller financing/Section 453 is the starting point for a couple of great strategies for deferring capital gains tax. But why not take it to the extreme and assume a 30-year interest-only sales contract? Now all of your capital gains are deferred for 30 years and you'll have 30-years of interest income (taxable).

The problem with this is that you have default and prepayment risk. If your buyer refinances, there goes your annuity! If your buyer defaults you are screwed as well. There are a few ways to secure the transaction by using a trust in the middle. This eliminates both the default risk and the prepayment risk. But it doesn't put cash in your pocket. The monetized installment sale approach allows for you to get cash at closing and still get 30-years of tax deferral.

If you want to get really sophisticated, what you could do (hypothetically speaking, because this is not tax advice) is capitalize a new LLC with enough assets each year to equal 50% of your adjusted gross income. Make sure the LLC units are non-voting and non-controlling and gift those shares to a charity. Nothing changes in your LLC. All of the cash and real estate is still held by the LLC and you are the manager of the LLC. Business in the LLC goes on as usual. At the end of the year when you do your taxes, a K-1 will be generated for the charity. The profits, however, are still sitting in the coffers of the LLC.

You use that tax savings to pass some of the wealth on to the charity and you also purchase a life insurance policy on yourself. The purpose of the life insurance policy is to make sure that when you do eventually pass away, you replace all the wealth you built up in that LLC (owned by a charity) with death benefit for your children/heirs. Its no different from what people do with a CRT, only the LLC is a better structure for controlling your wealth creation. You can also name an heir as the successor manager of the LLC so that this can be repeated in perpetuity.

You really need to be in the top income tax brackets for the arbitrage to work out. i.e. the tax savings is enough to pay for the life insurance and give something to charity. Its tight in the first few years, but the premiums stay constant and the wealth in the LLC is constantly growing. But you've still got the benefit of the tax deduction in the first few years.

This is not for the faint of heart. Consult a professional.

Dave Foster · Answer

@Brenda Whittaker

First, Sec 121 of the IRS code allows you to sell a house that you live in and as long as you have lived in it for 2 out of the 5 years prior to sale you can take the first $250K ($500K of gain if married) tax free.  You can do this once every two years.  So you could sell the house you're living in and take the first $250/$500K of profit tax free.

Second, you can always convert an investment property you own into a primary residence.  You do that by moving into it.  Once that happens then you now live in a house that you own and sec 121 applies.  When you convert a house that way you must live in it again for 2 out of the 5 years prior to selling it and you can once again take an amount of the gain tax free.  The difference when you convert it is that when you sell you must recapture all depreciation  and you'll only get to prorate the amount of gain between the periods of "qualified use" (as a residence) and "non-qualified use" (as a rental).

So if you sold your current house now you would get the profit tax free.  If you then moved into one of your rentals and lived there for 2 years you could then sell it.  This time you would have to recapture depreciation from the time you rented it but you could then take 2/11ths of the gain tax free. (the prorata ratio of the 2 years you lived in it and the 9 years you rented it.)

Where this all comes into my world of 1031 is that if your rentals were not near you or not the kind of place you'd want to live you can sell a rental and use a 1031 exchange to buy a really nice rental near you.  After you have used that new property for investment for a year or two to satisfy the "intent" part of 1031 you can again move into the property.  When you do this with a property that has been the subject of a 1031 exchange you have the same restrictions as above with a conversion and one additional one - you also must have owned the house a total of 5 years before you can sell and take the sec 121 exemption.

That's how 1031 investors carve out tax free cash as they go through their investing careers.  I have clients that use it as a game of "where do we move in our retirement next" kind of thing.  They're having fun and reaping the benefits of converting hard earned tax deferred dollars into tax free dollars.

Brenda Whittaker · Answer

Thank you everyone!  @Dave Foster , very curious, your last statement here, conversion into primary residence?  Can you clarify that for me?  What is available every 2 years?   I have 2 unfortunate mortgages against my home I should never have taken out, (borrowed to invest in rental property) now with very very low income from rents only and no job, I am afraid of not being able to have a free and clear home anymore, my goal is to get rid of those 2 mortgages as I cannot afford them but I have 2 free and clear rentals that I have owned for 9 years.  I'd like to sell one and pay off at least one mortgage, so is there a way to do that and avoid most of that capital gain?  Better would be to take the cash from a sale and reinvest but I am lacking the confidence to risk all that cash, after being clobbered by bad real estate investing thus so far.  Thanks for listening. I gotta get out of these mortgages.

David Faulkner · Answer

Another thought, please confirm with a CPA, to do what you want to do may be to sell the property with owner financing ... this I believe if structured properly would spread the capital gains out over the term of the installment sale, and if that amount stayed below the tax bracket I think it could in fact stay tax free ... there are also some cool legal accounting tricks you could use to take some above the line and below the line deductions to up your income and still come out tax free ... this blog, though not RE related, could give some ideas about how to go about doing that:

http://www.gocurrycracker.com/go-curry-cracker-201...

And to the comment on why you would like to retire making less than you do working ... I'd say cost of living does not equal quality of living ... if someone wishes to and is able to retire earlier than they otherwise would be able to and have more years and younger years to enjoy it but with a smaller retirement income, then that is a worthy trade worth considering IMO ... the example above shows how you can earn $100k+ tax free, which is the equivalent of say ~$130k of taxable income ... couple that with a free and clear primary residence (so lower expenses) and I'd say that can be pretty good livin' for most. It may not be for everyone, but I certainly wouldn't dismiss it outright without any consideration.

Brenda Whittaker · Answer

So, what is the best way to deal with capital gains?  How can we at least minimize them?

Jack B. · Answer

I think I found the answer. It looks like capital gains are added to your taxable income for determining tax bracket for the capital gains tax. So while the capital gain is taxed at the capital gains rate, the capital gains bracket you fit into will depend on the aggregate of your W2 income and your capital gains, thus in my scenario, thrusting you into the highest capital gains tax bracket there is.

https://www.nerdwallet.com/ask/question/do-capital-gains-affect-tax-bracket-26135

0 capital gains tax if tax bracket is less than 15%??

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