Owning rental property comes with a wide range of benefits. It allows you to diversify your investments, make a passive income, build equity, hedge against inflation, and enjoy tax benefits. In addition, your property is likely to increase on value over time due to real estate appreciation. This means that you can sell it for a good profit a few years down the line.
However, you need to realize that the capital gains earned when selling an investment property are subject to taxation. In this article, we will explore some tips and tricks that will help you avoid capital gains on rental property during a sale.
What Are Capital Gains?
A capital gain is defined as the net profit realized when a capital asset is sold. The Internal Revenue Service (IRS) categorizes everything used or owned for investment purposes as a capital asset. When an investor sells the asset, the capital loss (or gain) is calculated by deducting the realized amount from the adjusted basis.
Let us break down the key terms involved in calculating capital gains on rental property:
- Capital assets: Stocks and bonds, land, equipment and machinery, real estate, furniture and fixtures, etc.
- Adjusted basis: Initial price paid for the capital asset. This includes fees paid for purchasing the property such as title insurance, surveys, transfer taxes, sales commissions, and recording fees.
- Realized amount: This is basically the sales price minus any fees or commissions paid.
Adjusted basis (what you paid) minus realized sales price (how much you sold it for) = Capital gain or loss
What Is Capital Gains Tax?
What is capital gains tax on the sale of a rental property?
As mentioned earlier, federal capital gains tax is paid when you sell an asset or investment for more than what you paid for it. The amount of tax paid will be determined by how long you have owned an asset before selling.
- Short term capital gains tax: This is tax paid on profits made from sale of rental property held for 12 months or less. Short term capital gains tax is in the same tax bracket as your ordinary income tax.
- Long term capital gains tax: This applies to rental properties held for longer than 12 months. The tax rate is 0%, 15%, or 20% depending on your filing status and taxable income. Generally, long term capital gains tax rates are lower than short term capital gains tax rates.
How to Calculate Tax on the Sale of an Investment Property
How is capital gains calculated on the sale of a rental property? As mentioned earlier, the tax rate for short term capital gains on rental property is similar to that for ordinary income.
According to the IRS, here is how long term capital gain tax is calculated:
- 0% if taxable income falls below $80,000
- 15% if taxable income falls between $80,000 and $441,450 for singles
- 15% if taxable income falls between $80,000 and $496,600 for qualifying widower or married filing jointly
- 15% if taxable income falls between $80,000 and $496,050 for head of household
- 15% if taxable income falls between $80,000 and $248,300 for married filing separately
- 20% if taxable income exceeds the limits set for the 15% capital gain rate
However, there are few exceptions when capital gains tax rate could exceed 20%.
How to Avoid Capital Gains Tax on Rental Property
Depending on the profits made from property sale, capital gains on rental property could go as high as hundreds of thousands of dollars. As a result, a real estate investor might have to pay up to 20% tax on their realized profits. The good news is that there are some strategies investors can use to defer, reduce, or avoid paying any tax on capital gains tax on real estate property.
Offset Gains With Losses
The IRS allows rental property owners to deduct operational losses from their taxable income. Therefore, one of the best strategies for minimizing capital gains tax payable is to offset the profits earned from selling property with losses incurred from another investment. This is commonly referred to as tax-loss harvesting.
Let’s say you made $40,000 in capital gains from the sale of rental property in the current year. In the same year, you lost $40,000 in the stock market. You could sell some of your stocks to realize a $40,000 loss which allows you to offset the $40,000 in capital gains on rental property.
1031 Tax Exchange
The 1031 exchange is derived from Section 1031 of the Internal Revenue Tax Code. It allows investors to defer paying capital gains taxes if they use the profits made from selling real estate into buying another ‘like-kind’ property. ‘Like-kind’ means that the property you buy must be the same type as the original home. In addition, the timing of a 1031 tax deferred exchange is as important as the property type. From the date of selling your rental property, you have only 45 days to find a potential replacement property, which you must close on within 180 days. If you miss the deadlines, you will have to pay full capital gains taxes on the original rental property for sale.
It is important to note that the 1031 exchange merely defers paying capital gains on rental property. However, taxes will be due once capital gains are realized from a home sale.
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Change Rental Property to Primary Residence
In terms of tax, it makes more economic sense to sell a home you live in than a rental property. Section 121 of the IRS tax code allows real estate investors to minimize capital gains tax by:
- Owning the property for at least five years
- Using the property as a primary residence for at least two of the five years preceding the sale
If you are considering converting a rental property into a primary residence, be sure to consult a tax professional first. This is because factors such as depreciation recapture might need to be taken into consideration.
Home Improvement
As mentioned earlier, real estate investors are allowed to deduct fees from the realized sales price. This includes transfer taxes, closing settlement cost, inspection fees, legal fees, sales commissions, and appraisal fees. In addition, investors can also deduct costs of home improvement. Renovating your investment property for sale will therefore increase its value and lower the amount of capital gains on rental property. Home improvements could include the following:
- Upgrading windows and doors
- Fitting new roofing, flooring, or appliances
- Replacing cooling and heating systems
- Upgrading plumbing or electrical fixtures
Buy Homes Using Your Retirement Account
Real estate investors can use retirement accounts like 401(k) plan, Roth IRA, or IRA to purchase single family homes, apartments, multi family homes, or condos. The IRS doesn’t levy any tax on rental income or capital gains earned from property bought using retirement accounts. However, you must fulfill certain conditions before owning real estate in your IRA.
Conclusion
If you don’t plan ahead, you might end up giving up a large percentage of your capital gains on an income property for sale to the IRS. With the strategies listed above, you can defer, lower, or completely avoid paying capital gains tax when selling rental property. Do your research and make wise choices. However, don’t just depend on real estate articles to provide all the answers. Be sure to consult a qualified and experienced local tax professional for tailor-made advice on your own rental property situation.
If you decide to opt for the 1031 exchange option, be sure to sign up for Mashvisor. You can find your next rental property with a few clicks of a button.