If you own property, chances are you have seen a significant increase in its value in the past several years. Even though mortgage rates remain at the highest levels in over a decade, property values remain high in many markets nationwide. While this growth is a massive win for those invested in real estate, selling these properties at market value also means investors will owe more capital gains tax when they sell, especially in highly-appreciated markets like Southern California.
According to Redfin, the average home in La Jolla, CA, was worth $2.3 million in September 2024, an increase of 21.8% over the previous year. This means an average home purchased just one year ago could be worth over $400,000 more today. The seller would have $400,000 in capital gains and owe roughly 37% of that tax in California.
This amount is significant. However, the capital gains taxes on investment properties held longer than one year or worth more than the average home can be staggering. While there is no way around paying taxes on the money you earn on your investments, you can control how much capital gains you owe at the time of sale by using specific capital gains tax planning strategies. They can help you maintain control over your money and your investments.
Why Not a 1031 Exchange?
While a 1031 exchange is a common tool used to defer capital gains on real estate sales, there are challenges to successfully using this strategy.
Timeline
A 1031 exchange allows you to reinvest the proceeds from your real estate sale in a similar property. But you find the property in 45 days and complete the purchase in 180 days. Even though the number of multimillion-dollar properties is growing, finding the right investment on a short timetable may not be possible.
Increasing Debt
To qualify for a 1031 exchange, the new property value must be greater than or equal to the one you sold. This requirement means you must reinvest your original investment and the growth. You may even have to invest more money.
Higher Interest Rates
Selling your property financed at 3% will mean letting go of your lower interest rate. A higher property value and a higher interest rate will lead to much higher payments on your investment property.
Why Worry About Capital Gains in Real Estate?
To illustrate the impact of capital gains on real estate transactions, let’s examine the listing of 1900 Spindrift Drive in La Jolla, CA. This stunning home, known to local residents as the Sandcastle Estate, is listed for $108 million. It is located on a cliff overlooking the Pacific Ocean. The 12,981-square-foot property is an iconic landmark that is sure to profit the owner millions. How do we know? Let’s take a closer look.
The property where the Sandcastle now sits was last sold in 2009 for $18.15 million. However, the house itself was not built until 2015, so we can assume this sale was for the land only. To determine the property’s cost basis, we need to add the cost to build the house.
We’ll conservatively estimate that the cost to build a magnificent house on the cliff’s edge was $600 per square foot. Since the house is 12,981 square feet, we approximate the total cost to build the house was about $7.7 million. When we add the purchase price of the land plus the cost of building the house, we get to a cost basis of $26 million. This is the owner’s cost. Any increase in sales price above this number is considered capital gains and subject to capital gains tax when the property sells.
If the property sells at the list price of $108 million, the capital gains would be in the neighborhood of $82 million, and capital gains taxes (calculated at 37%) would be $30.34 million. That is a huge tax bill for the seller and a significant portion of the gains on their investment.
How Can a DST Help?
A Deferred Sales Trust (DST) may not be the first strategy that comes to mind for real estate transactions when faced with a large capital gains tax. However, if you are selling a highly appreciated property, it could be your best option. If the owner of this property sets up a DST prior to the sale of the house, all of the proceeds from the sale go into the trust. The owner would not receive their principal investment or capital gains at the time of the sale. Thus, they would not owe any capital gains taxes because they do not realize any capital gains. Deferring capital gains tax on real estate is the first benefit of using a DST to sell real estate.
Yes, the owner will owe taxes on capital gains they remove from the trust, but they can control when that happens. The second benefit of a DST is that it allows investors more flexibility for reinvesting their money. Unlike a 1031, which only allows investors to use the proceeds to invest in like-kind real estate, a DST has no such restrictions. Investors may decide to invest the funds in their DST in Bitcoin, stocks, a different type of real estate, or another investment. If reducing investment risk is a goal, a DST is a great tool to achieve that.
As an added bonus, a DST also eliminates estate taxes on the sale proceeds. With the help of a qualified Deferred Sales Trust expert, you can decide how to leverage the growth of your real estate investments instead of giving a significant percentage to the government.
A Proven Tax Strategy
Real estate investing can be a great tool to build your wealth. If you are paying capital gains on increasing property values, you may be losing out on a lot of potential growth. A DST can help you delay your capital gains taxes and continue to grow your investment in the way that makes the most sense to you.
Since 2018, Capital Gains Tax Solutions has helped thousands of investors successfully take charge of their investing through a DST. Though some clients have faced state and IRS audits, they have all been closed out with no changes required, even in California. If you are planning to sell a highly-appreciated property or other asset, we can help you defer your capital gains taxes and retain control over your investment strategy.