Real estate and other types of investments can play a central role in helping you grow your wealth. Unfortunately, they can also surprise you with substantial capital gains tax. While you can’t always avoid incurring capital gains tax, you can take steps to minimize it. Here are a few strategies to consider.

Make a Section 1031 Exchange to Defer Capital Gains Tax

Section 1031 exchanges (also known as “like-kind exchanges”) allow you to defer any capital gains tax on the sale of an investment property if you reinvest the proceeds into a similar property within a given timeframe. Specifically:

  • You must identify potential replacement properties within 45 days of the sale
  • You must receive and close on the new property within 180 days of the sale

This strategy defers capital gains tax instead of eliminating it. However, it’s important to note that you can repeat the process each time you sell an investment property.

Take Advantage of the Long-Term Capital Gains Rate

When you sell an investment property, vacation home, or other piece of real estate, capital gains tax is assessed based on how long you’ve held the property. 

If you held the property for one year or less before selling, you’ll pay short-term capital gains tax. If you held it for more than a year, long-term capital gains taxes will apply. The tax rates are much different:

  • Short-Term: Your highest federal income tax rate (0%–37%)
  • Long-Term: 0%, 15%, or 20%, depending on income

Given the fact that short-term capital gains are taxed at your highest marginal rate, it’s almost always better to wait at least a year before making a sale.

Sell When Your Income Is Lowest

Your income is a major determinant of the capital gains you pay.

If you have a steady income and don’t anticipate retiring or taking a year off anytime soon, the timing of your sale may not matter as much. However, if you expect your income to be significantly lower for any reason, selling an investment property during that time may result in major tax savings.

Gift the Property to a Charitable Remainder Trust

If you want to continue earning income from your property without selling it in the traditional sense, consider a charitable remainder trust. These trusts are tax-exempt, so the sale of a property held within the trust won’t generate capital gains tax.

With a charitable remainder trust, you (and other beneficiaries, if you wish) will receive annuity payments for either a term of 20 years or until the death of the last beneficiary. After that, the remaining assets in the trust will go to a charity of your choice.

Some people refer to these as a Capital Gains Avoidance Trust. But in reality they dfer the tax and spread it out over time. The result is often tax savings because, by spreading out the gain, you can keep yourself in a lower tax bracket. Tax savings can amount to as much as 8.8 points – paying 15% rather than 20% plus 3.8% Net Investment Income Tax.

Installment Sales to Family Members

Selling real estate or investments to a family member using an installment sale can help spread capital gains over multiple years, reducing the overall tax burden in any single year. This method allows you to structure the payments so that you remain in a lower tax bracket while also potentially benefiting from lower interest rates within the family. However, the IRS closely scrutinizes these transactions, so proper documentation and fair market valuations are essential to avoid unintended gift tax consequences.

Installment Sales to Third Parties

An installment sale to a third party enables sellers to defer capital gains tax by receiving payments over time rather than in a lump sum. This strategy can be especially beneficial when selling highly appreciated assets, as it prevents a large tax liability from being triggered in a single year. However, sellers should be mindful of potential risks, such as default by the buyer, and may want to secure the sale with collateral or a promissory note.

Holding Till Death for Cost Basis Step-Up Under IRC Section 1014

One of the most powerful ways to minimize capital gains taxes is to hold appreciated assets until death, allowing heirs to receive a step-up in cost basis under IRC Section 1014. When an asset passes through an estate, its tax basis is adjusted to the fair market value at the date of death, effectively eliminating any unrealized capital gains. This strategy is particularly beneficial for highly appreciated real estate and stocks, as heirs can sell the assets shortly after inheritance with little to no capital gains tax liability.

Using Spousal General Powers of Appointment for Step-Up in a Joint Trust

For married couples, structuring a joint trust with spousal general powers of appointment can help maximize the step-up in basis upon the first spouse’s death. This technique allows the surviving spouse to adjust the tax basis of all trust-held assets to their fair market value, minimizing capital gains taxes upon future sales. Proper drafting of the trust is crucial to ensure that these powers qualify under IRS rules, so consulting with an estate planning attorney is highly recommended.

Moving to Puerto Rico

Under Puerto Rico’s Act 60 (formerly Act 22), eligible U.S. taxpayers who establish bona fide residency in Puerto Rico can significantly reduce or even eliminate federal capital gains taxes on investments accrued after their move. This strategy can be especially advantageous for investors with substantial unrealized gains, but it requires strict adherence to residency and sourcing rules to qualify for the tax incentives. Before making such a move, individuals should consider the impact on estate taxes, U.S. state tax obligations, and the long-term feasibility of relocating.

Using NING (Nevada Irrevocable Non-Grantor Trusts)

A Nevada Irrevocable Non-Grantor Trust (NING) can be a powerful tool for high-net-worth individuals seeking to minimize state capital gains taxes. By placing assets into a NING trust, individuals who reside in high-tax states can potentially avoid their home state’s capital gains tax on trust-generated income. This strategy requires careful structuring, as the trust must be administered in Nevada with a qualified trustee, and state tax authorities, like California’s Franchise Tax Board, may challenge aggressive tax avoidance tactics.

Minimize Capital Gains on Investment Property

A smart investment strategy includes a detailed plan for reducing capital gains tax. The experienced team at Boyd and Boyd can help you create one. Call us at (508) 444-9688 or contact us online today to get started.

 

FAQ

What Is the Capital Gains Tax Rate?

The capital gains tax rate can be 0%, 15%, or 20%, depending on your income.

How Can I Minimize Capital Gains Tax on Real Estate?

You might consider like-kind exchanges, selling after holding the property for over a year, selling when your income is lowest, or gifting the property to a charitable remainder trust.