Owning a rental property is an excellent investment for a couple of reasons. First, it can help generate steady, passive investment income through rent. Second, it can generate a large sum of money when it appreciates in market value.
Unfortunately, owning a rental property can significantly impact your tax bill through property taxes and capital gains taxes when you go to sell the rental property.
Here’s a quick guide to help you understand capital gains taxes and how they’re applied toward the sale of investment properties.
What is a Capital Gain?
Anything you own and use for personal or investment purposes is considered a capital asset. Capital assets include real property and personal property like homes, furniture, and stocks. “Capital gain” is the term used to describe the money you earn from selling your home. If you sell your home for less than paid, it’s considered a “capital loss.”
Capital gains are calculated on a cost basis.
According to the Internal Revenue Service (IRS), capital gains are either short-term or long-term. They impact your capital gains tax. In real estate, a short-term capital gain refers to money earned on selling a property you owned for less than a year. A long-term capital gain is any money made on selling a property you held for more than one year.
What is Capital Gains Tax?
In real estate, capital gains tax is the tax you pay on a capital gain made when you sell a property. It’s a federal tax that’s paid to the IRS.
For example, let’s say you purchased a house three years ago at a purchase price of $175,000 and sold it for its current market value of $225,000. Your profit, or capital gain, is the net difference between your purchase and selling prices. In this example, the gross income, or capital gain, on the sale of the property is $50,000. If you don’t qualify for any tax deductions, you’ll pay a capital gains tax on that $50,000.
The long-term capital gains tax rate is typically no more than 15%. However, your capital gains tax rate depends on:
- Your income tax bracket
- Your tax filing status
- Whether it was a short-term or long-term capital gain
- Whether it’s an investment property or primary residence
We’ve broken down capital gains tax rates by income to make it easier.
Individuals with taxable income less than or equal to $40,400 and married couples with taxable income less than or equal to $80,800 may not have to pay any capital gains tax.
Individuals earning $40,400 – $445,850 and married couples earning $80,800 – $501,600 pay a capital gains tax rate of 15% on long-term capital gains.
If an individual or married couple’s taxable income exceeds those above, they pay a capital gains tax rate of 20% on long-term capital gains.
The rates shared above are long-term capital gains tax rates.
Short-term capital gains tax differs because the IRS taxes short-term capital gains like ordinary income. That’s right. Short-term capital gains tax rates are the same as ordinary income tax rates. As a result, you could pay a capital gains tax rate of 10 – 37%, depending on your tax bracket and whether you’re an individual, head of household, or married filing jointly.
Capital Gains Taxes on Rental Properties
Owning a home is never tax-free, whether it’s your principal residence or investment property. And many real estate investors find they pay more taxes for their rental property than for their main home. This is especially true for capital gains tax.
As with property taxes, rental properties do not have the same tax exemptions as primary residences. If you profit from the sale of a rental property, you will pay capital gains tax.
However, there are some ways you can lower your tax liability when selling your rental property.
Capital Gains Exclusions
IRS Publication 523 is the official guide on selling your main home or investment property and preparing your tax return after the sale. It also includes detailed information about capital gains exclusions. We recommend you read the document carefully and speak to a real estate agent or tax advisor before filing your tax return.
Below are high-level summaries of ways to lower your capital gains tax liability on selling your rental property. Use it as a guide when working with a certified tax advisor.
5 Ways to Lower Your Capital Gains Tax Liability on Rental Properties
1. Track and Deduct all Expenses
Qualified tax deductions allow you to lower the amount of taxable gain. Keep track of any expenses related to maintenance or home improvements you made to your rental property. These may include a new roof, exterior paint, kitchen renovation, or bathroom remodel. You should also track any legal or advertising fees you paid to write rental agreements or attract tenants. Closing costs are also tax deductible. Think of your investment property as a small business. Any money you spend to keep or sell the property may be deductible and help lower your capital gains tax liability.
2. Opt for an Installment Sale
The IRS defines an installment sale as “a sale of property where you receive at least one payment after the tax year of the sale.” In other words, you don’t have to receive one giant lump sum on selling your rental property. In a sense, the homeowner acts as a lender of sorts to the purchaser. Installment sales allow the seller to spread the payment over a set timeframe. Each amount they receive from the purchaser will consist of three parts – principal, gain, and interest. You, the seller, then pay capital gains tax on a fraction of your capital gain each year, reducing your overall tax payment. It’s like taking the installment payments over the lump sum if you win the lottery because it means you pay less taxes and put more money in the bank.
3. Defer Capital Gains in a 1031 Exchange
The IRC Section 1031 is a tax code that allows you to postpone paying a capital gains tax. To qualify, you must reinvest the capital gain earned in selling an investment property into a similar property or properties. That’s why it’s also called a like-kind exchange. There are some strict rules and regulations around a 1031 exchange, but it does allow you to defer paying capital gains taxes almost indefinitely – as long as you keep investing in like-kind exchanges.
4. Invest in an Opportunity Zone
Opportunity Zones were created under the Tax Cuts and Jobs Acts of 2017. They’re a tool to spur economic development in underprivileged communities. To attract investors, the IRS offers a capital gains tax deferment for taxpayers who invest their capital gains into a Qualified Opportunity Zone. The deferment lasts until December 31, 2026, unless you have an inclusion event.
5. Make it Your Principal Residence
A principal residence is your primary home, and primary homes qualify for tax deductions and capital gains exclusions that don’t apply to rental properties. To establish a property as your primary residence, you must live in it for at least two years before you sell it. You can rent out your other home in the meantime and move back in after your rental property sells. It may sound cumbersome, but it isn’t, and the tax breaks for a principal residence add up. For example, individual homeowners may be able to exclude up to $250,000 in capital gains from their taxable income. Married couples may be able to exclude up to $500,000 in capital gains from selling a primary home. The downside of making your rental property your principal residence is that you cannot deduct any market value depreciation because you lived in the house.
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