Mental Accounting and Avoiding Capital Gains

“Up up down down left right left right B A Start, 

Just because we use cheats doesn’t mean we’re not smart.”

– “Anyone Else But You” by The Moldy Peaches

This week I caught up with Tom Wheelwright on his brand new book The Win-Win Wealth Strategy: 7 Investments the Government Will Pay You to Make. The question on my mind was how can equity-rich homeowners avoid capital gains when selling? 

Over the past few years, we’ve seen unprecedented appreciation. At the end of the first quarter of 2022, the total U.S. home equity surged to a record $27.8 trillion. That means many of your sellers, maybe for the first time, won’t be able to roll all the sales proceeds into their next home. They will owe capital gains taxes on the sale. 

Tom quickly walked me through a scenario where a homeowner could avoid capital gains, buy an asset, and make money on the deal. But, before I share his answer, I need to explain “mental accounting.”

“Mental accounting” is a concept identified by Robert Thayer, the Nobel-Prize-winning behavioral economist. The basic concept is that we tend to sort our money (and time) into irrational buckets and, therefore, make poor decisions with it. Imagine going to a casino with $100. You hit a lucky streak and suddenly you’re staring at $500 in chips. You decide to keep playing and eventually walk home with $300. How much did you win or lose? 

Most people answer: You won $200. You walked in with one Benjamin and walked out with three! But the right answer is you lost $200. We get this wrong because we consider the winnings “house money.” You had $500 dollars at one point but walked out with only $300. “House money” is still money. You can thank me (or curse me) for this insight next time you’re in Vegas! 

What does this have to do with sellers and their equity? Many sellers may treat the crazy equity gains of the past few years as a literal form of house money. Just because they can afford to pay Uncle Sam, doesn’t mean they should. It’s our job to help them make smart decisions. 

So here is Tom’s answer with one critical caveat. Tom is a CPA. I am not. And even he recommends you do this with the advice of your very own tax adviser. Got it? 

Tom shared, “It’s money that is earned and spent or saved that is taxed. Money that is invested is not taxed. They need to remember that if they re-invest the money, and invest it in one of the seven investments I talk about in The Win-Win Wealth Strategy, then they won’t pay tax at all.” 

Here’s the scenario he offered. Your seller nets $350,000 on her home sale. She will use the tax-protected gains of $250,000 toward her move-up home. However, she still owes capital gains on the $100,000 above that threshold. She is in the top tax bracket and would owe 24% or $24,000 to the IRS next April 15. 

Instead, with Tom’s help, you show her how she can re-invest the $100,000, gain a rental property, and save on her tax bill. 

“Take the proceeds and reinvest into a rental property, get bonus depreciation, which will offset the capital gains,” he shared. “It’s the gain portion that you need to make sure you invest. And you need to make sure with real estate that you add debt. Because in order to get the full benefit of the tax law, you have to use debt to maximize your depreciation.” 

“Bonus depreciation” in this example is using cost segregation which he explains in detail in chapter 4 of his new book. Normally, the value of residential real estate, excluding the land, can be depreciated over 27.5 years. By paying a few thousand for a cost segregation study, the value of the rental can be divided into the land, building, land improvements, and the contents of the structure. Under the 2017 Tax Cuts and Jobs Act (TCJA) 100% of the value of the land improvements and contents can be depreciated in 2022. 

So if your seller takes her $100,000 and buys a $500,000 rental with a mortgage covering the balance. The bonus depreciation on the land improvements and contents should fully offset her tax bill from the capital gain. Tom notes, “With cost segregation, typically the contents and land improvements add up to 20 to 30% of the total cost of the property.” 

Note, starting in 2023, the bonus depreciation will drop to 80% so there is some urgency to find a rental. It must be purchased this year to get the full benefit. 

Tom shared this bonus nugget, as well. “If you’re in the top bracket, it means you have other income. And the deduction from the depreciation offsets the other income, which is being taxed at 37%. So you can actually make money on the deal…The government is literally paying you to make this investment.” 

Bonus depreciation is knowledge every seller and real estate investor (and their agent) needs to know. 

One question to ponder in your thinking time: Where do I have gaps in my real estate knowledge I can fill to better serve my clients?

Make an Impact!
Jay Papasan

Co-author of The One Thing & The Millionaire Real Estate Agent ​

​