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Capital gains are an increase in the value of an asset over time, which is only realized when selling that asset. In real estate, for example, capital gains relate to the profit that an investor makes when selling an asset that has increased in value. Taxes are paid on capital gains, and the rate used to tax capital gains depends on a number of factors including the period of time that an asset is held and the seller's tax bracket. But there are ways that a real estate investor can reduce or defer his or her capital gains taxes owed to the government. 1031 Exchange — When an investor sells a property, instead of taking the proceeds out at closing, the proceeds are held by a licensed "qualified intermediary." The investor then has 45 days to find a replacement property or properties and 180 days to close on the replacement property. The funds are then transferred at closing and used to purchase the new property. Eventually, you will have to pay the tax when you sell the replacement property but in the meantime, you can keep rolling the gains into a new 1031 exchange. The 1031 exchange is a legal IRS-recognized transaction, but has a few rules that if ignored, may invalidate the exchange, so it's important to find out all you can before you sell the property in question. Capital improvements — The costs of owning the property—maintaining its functionality and keeping its systems working can be a capital gains write-off. The rule of thumb is that the improvements must be permanent to the property. Replacing a stove won't qualify, but replacing a roof or upgrading a furnace will. Keep a file of all of the capital improvements you make to the property. For rehabbers, this is a "must" to maximize your profits. Installment sales — If you are the seller of a property, you can defer capital gains taxes through a "self-directed" installment sale. This means that you sell the property by way of a "land contract" or "agreement for deed." In this case, you are acting as the bank and the buyer is making monthly payments to you to purchase the home.
Be aware that you can also defer capital gains by investing in real estate using your IRA. Profits from a tax-deferred account are not subject to capital gains taxes until the money is taken out of the account, then it is taxed as ordinary income. Taxes are inevitable, and they are needed by the county, state, and nation to provide public services to the citizens. However, you don't want to pay more taxes than you have to. Talk with your accountant or tax preparer to see what steps you can take to lower the capital gains taxes you pay on your investments.
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