You might know the Mark Twain saying, “Invest in land, they aren’t making it anymore.” Twain was commenting on one of the fundamental reasons to invest in real estate. There are plenty of other reasons and advantages, among them the tax code provisions that allow an investor to avoid taxes on selling or flipping real estate.
Home as Investment
Tax law allows an owner to profit up to $250,000 for a single person, and $500,000 for married couples, on the sale of a principal residence without having to pay any tax. The tax code requires the owner to own the home at least two years and to have lived there at least two of the last five years before selling. This rule can be used serially, allowing a homeowner to buy and sell a home every two years without paying any tax on profits within the prescribed limits.
The 1031 exchange, so named for the relevant tax code section spelling out its rules, permits an investor to sell a property without paying taxes by buying a replacement property. Quite a few precise rules apply. For starters, the property must be a rental owned for at least a year. By the time the owner sells, he must have identified a “qualified intermediary” – an unrelated third party – to hold the sale proceeds. He must identify a replacement property of equal or greater value within 45 days, put the sale proceeds into the purchase of the replacement property and close the purchase within six months of the sale.
Invest with an IRA
For the seasoned real estate investor, another option exists. The IRS permits taxpayers to use retirement funds to purchase investment real estate. When the property is sold, the principal investment and profits return to an IRA account, unscathed by taxes. If the IRA is a Roth account, the investor will never have to pay taxes on the profits. If the IRA account is traditional, taxes will come due at the time they leave the IRA account.
Carry Back a Mortgage
If instead of taking a profit from the sale of an investment property, an investor provides a mortgage to the buyer, he is not taxed on that portion of the profit represented by the mortgage until it is repaid. An investor, then, could get back his original investment back from a sale to finance his next investment and then offer the buyer a mortgage in the amount of his profit. The seller will receive a monthly mortgage payment until the mortgage is repaid. By using this investment method, the seller is taxed on his profits over time instead of all in one year while also creating a stream of income that can last for years.
Mary Gallagher runs Mary Gallagher Planning (mgaplanning.com), an urban planning and consulting business in San Francisco. She is the former assistant planning director for San Francisco and planning director for San Mateo. Gallagher has been writing about real estate, development and land use for numerous websites since 1995. She holds a master's degree in historic preservation planning from Cornell University.