Selling Your Rental Property? Here’s How To Avoid A Big Tax Bill
Sam Hawrylack6-Minute Read
March 08, 2021
Selling a rental property could put a lot of cash in your pocket, but it could line the pockets of the IRS, too. Fortunately, there are ways to offset the big tax bill you could face if you don’t plan for it. Capital gains are income, and the IRS wants its share. Here’s what you need to know. Capital gains on rental property sound good, but could lead to a serious tax bill if not handled right. Knowing what to expect long before you sell the property is important.
Capital Gains On Real Estate Investment Property, Explained
You buy investment properties with the intent to make a profit. But just like the income you make at your job, Uncle Sam wants his part of the profits.
You’ll pay capital gains taxes on real estate investment property when you sell it. A capital gain is the profit you make by selling a home for more than you paid for it. How long you own the property will determine the type of capital gains you pay.
If you own a property for less than 1 year, you’ll pay short-term capital gains, which are the same tax rates you pay on your income, otherwise known as ordinary tax rates. But, if you own the property for longer than a year, you’ll get more preferential tax rates on the long-term capital gains.
Because the sale of an investment or rental property is the sale of an asset, you’ll owe taxes at the appropriate rate based on the time you owned the property.
How Capital Gains Are Calculated On The Sale Of An Investment Property
Selling a rental property means you’ll pay taxes on the profits. First, you must determine if you have short-term or long-term capital gains. That’s easy enough to figure out – did you own it for 1 year or longer?
Next, determine the property’s cost basis and net proceeds. The cost basis starts with the amount you paid for the property, but to it, add the closing costs and the cost of any major improvements you made that improved the property’s value.
The net proceeds are the money you make from selling the property. This isn’t the full sales price. You’ll deduct the costs to sell the property, such as commissions and attorney fees, and transfer taxes from the sales price.
Your capital gains on rental property are the difference between the net proceeds and cost basis.
If you have short-term gains (you owned the home for less than a year), you’ll pay your marginal tax rate and depreciation recapture tax of 25%. For tax year 2020, tax brackets range from 10% – 37% depending on your income.
If you have long-term capital gains, you’ll pay lower tax rates of 0%, 15% or 20%. Most people fall within the 15% or 20% category. The amount you’re taxed depends on your household income and are as follows:
- Single filers making $40,401 – $445,850 pay 15% long-term capital gains
- Single filers making over $445,850 pay 20% long-term capital gains
- Married filing joint filers making $80,801 – $501,600 pay 15% long-term capital gains
- Married filing joint filers making over $501,600 pay 20% long-term capital gains
Strategies To Avoid The Capital Gains Tax
With a little planning, the good news is you can avoid or at least reduce your capital gains taxes. Here’s how.
Sell Your Primary Residence Instead
This is a little trick investors use all the time. If you sell your primary residence and move into your investment property, you may not pay capital gains taxes on your primary residence if you meet the following requirements:
- You lived in the house for at least 2 of the last 5 years you owned it.
- Your capital gains don’t exceed $250,000 for single-filers or $500,000 for married filing joint filers.
This works well if the investment property is suitable for your family. You can sell your primary residence, move into the investment property, and live there for at least 2 years. You can then do it all over again if you still want to sell the initial investment property.
Here’s an example.
Dan has a primary residence that he bought in 2010. He also owns an investment property that he thought about selling in 2018. He didn’t want the work involved with managing it anymore. But his capital gains were high – he earned around $100,000 on the property.
Instead of selling the investment property and paying the higher capital gains on real estate investment property, Dan sold his primary residence. Since he was there for more than 2 years, he could sell it and avoid capital gains taxes since he earned $150,000 on the home.
Now Dan lives in the investment property, which he’ll keep until he lives there for 2 years and can sell it, avoiding capital gains taxes on it too.
The IRS taxes you on total capital gains across all investments, not just real estate. For example, if you also have stock investments, you’ll pay taxes on the capital gains earned there too.
But, if you have a loss, it can offset the capital gains on rental property, which may lower the total taxes owed.
For example, if you have $150,000 in long-term capital gains from selling your real estate investment, but you have $50,000 in losses in the stock market, you’re only taxed on $100,000 in capital gains or the difference between your capital gains and losses.
Keep in mind, the IRS requires that short-term losses offset short-term capital gains first. If you have more short-term losses than gains, the remaining loss can be carried over to your long-term capital gains to decrease your tax burden even further.
Trade Up And Use Section 1031
If moving into your investment property isn’t an option, or you don’t have capital losses to offset your gains, consider a Section 1031 Like-Kind Exchange.
If you use the proceeds of your investment property’s sale to buy another similar property, you can defer the taxes on the capital gains. In other words, you transfer the gains from one asset to another – you don’t receive cash in hand for the sale.
This only works if you sell an investment property (not your primary residence or second home). There are strict timelines, though.
First, you must identify the property you’ll buy within 45 days of selling your investment property. You then have 180 days to close on the new property’s purchase (unless the tax filing date for the tax year you sold the home occurs first).
If you don’t meet the IRS timeline, you’ll owe taxes on the capital gains.
Buy And Hold Properties In Opportunity Zones
The Tax Cuts and Jobs Act created an incentive for real estate investors to invest in distressed communities. Investors with capital gains can invest the funds in Opportunity Funds, deferring tax liabilities until 2026.
The point of the funds is to spur growth in some of the country’s poor areas. Giving investors an incentive to invest there helps stimulate growth while providing investors with tax incentives.
To date, there are 8,700 geographic areas to invest in, and investors invest in an Opportunity Fund rather than buying a property directly.
As an incentive, investors defer taxes or potentially eliminate them based on the number of years they stay invested in the Opportunity Fund:
- Invest for at least 5 years, and the cost basis increases 10%.
- Invest for at least 10 years, and the cost basis increases 15%.
- Invest for over 10 years, and investors pay no capital gains on investments in the Opportunity Fund.
Don’t Forget About Depreciation Recapture
When you owned the rental property, you likely took advantage of the depreciation write-off. This allowed you to deduct the cost of buying and improving the home. The IRS allows you to write off a specific percentage of depreciation each year.
This helps lower your tax liability while you own the property. But, when you go to sell, the IRS wants some of that money back. They consider it part of your income, and you'll pay taxes on it. The IRS considers the depreciation part of your capital gains, but they tax it at your ordinary tax rate, not your capital gains tax rate.
Fortunately, the IRS caps the tax rate at 25%, even if your ordinary tax rate is higher. But, if you sell the property for a loss, you don’t owe depreciation recapture taxes.
A Little Planning Could Save You A Lot Of Green
Before selling a rental property, set yourself up for minimal tax liabilities. If you can move into the home, making it your primary residence, you’ll offset taxes completely. If that doesn’t work, consider a 1031 like-kind exchange.
Those aren’t the only options, though, and sometimes you just have to pay the taxes, but knowing how to minimize them along the way helps. Selling a property is a big undertaking, but there are ways to make it profitable and less overwhelming. Check out our Home Seller’s Guide to learn more.
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