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1031 Exchange: How to Save on Taxes When Investing

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1031 Exchange: How to Save on Taxes When Investing

Written by: Ben Mizes | Clever Real Estate

Uncle Sam always wants his cut.

However, just because we have to pay taxes doesn’t mean we enjoy it. And there’s nothing wrong with looking for ways to legally save on taxes. 

The good news is that there are many ways to save on taxes when investing. From municipal bonds to the power of the 1031 exchange, you have options to shrink that tax bill and keep more of your profits.

Let’s look at how.

Municipal Bonds

Municipal bonds are an excellent choice if you want to make a low-risk investment. If you do it right, they are also a tax-free one.

These bonds are issued by local or state governments, often to fund a particular project like a new hospital or school.

The federal government doesn’t tax municipal bonds. When you purchase bonds from your own state, you won’t have to pay state or local taxes on them either. However, if you buy bonds from a different state you’ll have to pay income tax on them. 

Deferred Taxes

Paying taxes is no fun, so why not put it off until later? There are many tax-deferred account types that allow you to do that. You may have heard of the most common ones, IRAs and 401(k)s.

These accounts, typically used for retirement, shelter money from taxes until it is time to withdraw. This is helpful in two ways. You get to earn interest on the money that you would have had to pay in taxes. Plus, when you retire you’ll presumably drop to a lower income tax bracket, meaning you’ll pay a less amount in taxes.

The big downside is that this money is not liquid — unless you want to pay the penalty that comes with taking it out early. 

Reinvesting Dividends

Instead of accepting dividends from your investments as income, reinvest them. Doing this can help keep down your taxable gain. Just don’t forget to deduct your reinvested dividends when you do your taxes. Otherwise, you could end up spending more on capital gains taxes than you should.

Clear as mud? Let’s look at an example.

When you invest, your profits are the only taxable amount. Let’s say you invest $7,000 in a mutual fund and sell it a few years later for $10,000. Simply speaking, you’d have to pay taxes on the difference, $3,000.

However, if your funds earned dividends that were reinvested in the account you can deduct. Many people don’t realize this and end up paying extra.

In our $7,000 example, let’s say that the funds earned $1,600 in dividends over time. Your capital gains should be calculated by deducting both the original investment and the reinvested dividends. This would be $7,000 plus $1,600 you’ll only pay taxes on the remaining $1,400 rather than the full $3,000.

Stock Contributions to Charities

Giving cash to charity increases the tax deduction you can take. However, with the recent raising of the standard deduction, fewer people are itemizing.

But that doesn’t mean that your charitable giving won’t benefit you come tax time.

Instead of giving cash to a charity, consider donating stocks. Donated stocks are exempt from capital gains taxes. Essentially you can give a bigger donation that won’t cost you any more.

For example, say you invested $1,000 in stock. It has grown to $1,400. At 30% capital gains tax, you’ll have to pay $120 in taxes to sell it. If you donate it, however, those taxes don’t have to be paid. Thus, a stock that is worth $1,280 to you is worth $1,400 to the charity.

Real Estate Investing

Investing in real estate is an excellent way to grow your portfolio. While the investment itself is not very liquid, you have the benefit of positive cash flow. As long as your units are occupied, rent will be coming in each month. Done well, the potential for returns far outpace the stock market.

Real estate is also a “safer” investment. The stock market is very volatile, and prices rise and fall based on decisions that companies make in which you have no say. When you invest in real estate, you make the decisions that affect the health of your investment.

Unlike stocks that you will trade frequently, real estate is a much more long-term investment. Why is this important? Because while it is continually rising in value you only have to pay capital gains taxes when you sell. Plus, the long-term capital gains tax rate is lower than that of short-term capital gains.

But what about the capital gains tax when you sell? As you get better with picking your investments, you may want to let a property go in favor of one requiring less maintenance or with more units. However, the thousands of dollars you’d have to pay in capital gains taxes will be quite a hit. Or will it? There are several ways to save on taxes when selling a real estate investment.

For example, the 1031 exchange. There are many rules you have to adhere to, but this strategy allows you to basically swap one property for another of similar or higher value. Use the money from the sale of the first property to buy the second and the sale is exempt from capital gains tax.

That’s thousands of dollars that you can put directly into your new investment. You’ll still have to pay capital gains tax at some point. But for now, when you need that money to grow your portfolio, you can keep it.

Many Options for Saving on Taxes When Investing

Paying taxes is a responsibility that falls on us all. Without them, we wouldn’t enjoy the same quality of life. They are necessary to fund roads, schools, national defense, and much more.

However, when you’re trying to grow your investment portfolio, capital gains taxes are a heavy burden that stifles that growth. Use these tips for saving on taxes when investing and you can watch your portfolio flourish

Related: Homeownership the Expensive Frontier of the American Dream

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