Selling an investment property that has appreciated significantly can trigger one of the largest tax bills of an investor's life. Between federal capital gains tax, depreciation recapture, the Net Investment Income Tax, and state taxes, a seller can lose a substantial portion of a gain to taxes in the year of sale. Several legitimate strategies exist to defer, reduce, or in some cases eliminate that tax liability. Below is an overview of the most common approaches, so you can have an informed conversation with your tax and legal advisors about which one may fit your situation.
What Triggers Capital Gains Tax on Investment Property
Capital gains tax on investment property is generally calculated on the difference between the property's adjusted basis (the original purchase price, plus improvements, minus depreciation taken) and the sale price. Two separate taxes typically apply. The portion of the gain attributable to depreciation already claimed is taxed as depreciation recapture, at a rate of up to 25% federally. The remaining gain is taxed at long-term capital gains rates, which range from 0% to 20% depending on taxable income, plus an additional 3.8% Net Investment Income Tax for higher earners. Many states apply their own capital gains tax on top of the federal bill, which means a seller in a high-tax state can face a combined rate well above 30% on a single sale.
Strategy 1: 1031 Exchange (Like-Kind Exchange)
A 1031 exchange allows an investor to defer capital gains tax by selling a property and reinvesting the proceeds into another investment property of a similar type, within strict IRS deadlines. Investors have 45 days from the sale to identify potential replacement properties and 180 days to close on one of them. A qualified intermediary must hold the proceeds throughout the process, since the seller cannot take possession of the funds at any point. A 1031 exchange can work well for investors who want to remain in real estate, but the tight timeline means deals can fall through, particularly in a competitive market. It also does not create liquidity, since the gain is deferred rather than eliminated, and the deferral resets again the next time the replacement property is sold unless another exchange is completed.
Strategy 2: Deferred Sales Trust
A Deferred Sales Trust offers a different way to defer the same tax. Instead of reinvesting in another property, the investor transfers the property to a trust before the sale, and the trust sells it to the buyer. The investor and the trust enter into an installment sale agreement under Internal Revenue Code Section 453, and the investor is generally taxed only as payments are received from the trust over time, rather than all at once in the year of sale. Because this strategy does not require reinvesting in like-kind real estate, it is often used by investors who want to exit property ownership and diversify the proceeds into a broader portfolio. Learn more about the full benefits of a Deferred Sales Trust, including asset protection and estate planning advantages.
Strategy 3: Qualified Opportunity Zone (QOZ) Funds
Reinvesting a capital gain into a Qualified Opportunity Zone fund can defer the original gain and, if the investment is held long enough, potentially reduce or eliminate tax on the new appreciation within the fund. QOZ investments carry their own rules, including a limited window to reinvest the gain and restrictions on which geographic areas qualify, so this strategy tends to fit a narrower set of investors than a 1031 exchange or a Deferred Sales Trust.
Strategy 4: Installment Sale (Seller Financing)
An investor can also sell directly to a buyer through an installment sale, carrying the note personally instead of transferring the asset to a trust. This spreads gain recognition over the life of the note in a manner similar to a Deferred Sales Trust, but the seller bears the buyer's credit and default risk directly, since there is no independent trustee managing the asset.
Strategy 5: Charitable Remainder Trust (CRT)
For investors with philanthropic goals, donating an appreciated property to a charitable remainder trust can eliminate capital gains tax on the donated portion while providing an income stream back to the donor for a set term or for life. What remains in the trust at the end of the term passes to the designated charity.
Strategy 6: Tax-Loss Harvesting to Offset Gains
Realizing losses elsewhere in an investment portfolio in the same tax year as a property sale can offset some or all of the resulting gain. This approach is often used alongside, rather than instead of, one of the deferral strategies above.
Strategy 7: Step-Up in Basis
Holding an appreciated property until death allows heirs to inherit it at its stepped-up fair market value, which can eliminate the built-in capital gains tax. This is not a solution for an investor who needs or wants to sell now, but it is worth understanding as part of a broader estate planning conversation.
Which Strategy Fits Your Situation
The right approach depends on whether an investor wants to remain in real estate, needs liquidity, has charitable intentions, or is thinking about estate planning. A 1031 exchange keeps proceeds in real estate on a tight timeline. A Deferred Sales Trust allows an investor to exit real estate and diversify without a fixed reinvestment deadline. (See our comparison of a Deferred Sales Trust vs. a 1031 exchange for real estate for a deeper look at how the two differ.) A Qualified Opportunity Zone fund fits a narrower set of circumstances. An installment sale or charitable remainder trust may fit specific income or philanthropic goals. Because each of these strategies has its own eligibility requirements and trade-offs, and because most must be set up before a sale closes, this is a conversation worth having with a qualified advisor well before signing a purchase agreement.