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Every investor wants to avoid being hit with a massive tax bill, and real estate investments are no exception.
Investing in real estate has plenty of upsides. Steady cash flow, passive income, long-term asset appreciation and tax deductions are just a few of those benefits. It’s no wonder rental properties are such a popular type of investment.
If only it was as easy as buying up rental properties and selling them for unrestricted profits later on. But like most instances when money exchanges hands, the IRS is ready to take a piece of the pie.
Luckily, there are some ways real estate investors can avoid paying the capital gains tax on investment properties, which we’ll explain further down.
What Is a Capital Gain?
A capital gain is profit made on the sale of an asset, like a home or investment property, that has increased in value during the holding period. This is called a “realized gain.” While you own the asset, the increase in value is called an “unrealized gain.”
On the other hand, a capital loss is just the opposite – the depreciation of an asset that results in a loss when that asset is sold. Clearly, no investor wants to find themselves in the latter position, but it can happen.
The IRS considers everything owned and used for investment purposes as a capital asset. Once an investor chooses to sell an asset, the capital gain/loss is calculated by subtracting the realized sale price from the original purchase price (also called the “tax basis”).
The amount of tax you’ll pay depends on a few factors, like your income tax bracket, marital status, amount of time you’ve owned the property and what kind of residence the home was classified as.
Let’s dive into how taxes work when it comes to a real estate investment property.
How Do Taxes on a Rental Property Sale Work?
A variety of factors can affect the tax you’ll have to pay on the sale of an investment property. We’ll review some of these important considerations below.
Cost basis is used to predict the amount of capital gains tax owed when a property is sold. It’s calculated by combining the original purchase price of the asset with any additional costs related to acquiring it. These costs may include real estate agent commissions, title insurance, appraisal fees and other eligible expenses.
Additionally, improvements made to the rental property that increase the overall value may be added to the cost basis. For example, a new roof or HVAC system would generally qualify as a property improvement.
The adjusted basis (also called adjusted cost basis) is calculated by taking the original cost to acquire the property and accounting for any increase or decrease in value. The adjusted cost basis is used to determine the capital gain or loss on the property sale.
Depreciation (sometimes referred to as a depreciation deduction in real estate) is a tax deduction that allows investors to deduct the cost of wear and tear over the term of ownership. This deduction helps recover the cost of maintenance or improvements.
According to the IRS, a residential rental property has a recovery period of about 27.5 years – meaning investors can deduct depreciation annually over this period of time. The annual deduction comes out to be 3.636% of the property’s initial cost basis.
It’s important to note that depreciation doesn’t equal loss of value. In fact, home values often increase over time, which has no impact on depreciation deductions.
Depreciation recapture tax
The depreciation recapture tax is essentially repaying the IRS for the depreciation expense taken by a rental property owner during the holding period. This tax is paid after the sale of the property and is taxed like ordinary income – up to a maximum of 25%.
Short-term capital gain
If an asset is sold after only being held for a year or less, the profit is considered a short-term capital gain. The tax rate is based on the investor’s filing status and taxable income for the year.
Depending on the investor’s tax bracket, the gain may be taxed at up to 37%. This is why it’s generally not advisable to sell an asset before the 1 year mark.
Long-term capital gain
Long-term capital gains tax rates are much more favorable, with most individuals qualifying for the 15% threshold. Of course, the final number will largely depend on the investor’s income level.
The highest tax rate you should ever have to pay on long-term capital gains is 20%. Even at the highest rate, this tax is much lower than ordinary income tax rates.
How Do You Calculate Capital Gains on Investment Property?
To calculate capital gains on an investment property, you’ll need to subtract the cost basis from the net proceeds you walk away with from the sale of the home.
For example, let’s say you bought an investment property 10 years ago for $100,000, and you’re able to sell it today for $300,000. You would also add associated expenses to calculate the cost basis. Let’s also pretend you paid $25,000 in initial closing costs and home improvements. Now, your cost basis is $125,000.
After paying commissions and fees following the sale of your rental property, we’ll say the net proceeds are $280,000.
(Net Proceeds) – (Cost Basis) = (Capital Gain)
That would be $280,000 – $125,000 = $155,000 total capital gain.
Once your final capital gain number is calculated, you can figure out how much you’ll pay in taxes by finding your income tax bracket.
Again, most people will meet the criteria for a 15% capital gains tax. The best thing to do is to speak with a tax professional to be sure.
How Do I Avoid Capital Gains Tax on an Investment Property?
There are a lot of creative (and perfectly legal) ways to minimize tax liability when it comes to capital gains. Let’s review a few popular ways to avoid capital gains tax on investment properties.
Use your retirement account to purchase property
Investors can leverage their tax-deferred retirement accounts, like IRAs or 401(k) plans, to grow their investment income and capital gains tax-free until withdrawing. As long as you don’t withdraw funds before retirement age (59 ½), you can delay paying capital gains tax and maximize growth.
Change the property to a primary residence
While this strategy isn’t worth the hassle for everyone, it can be a great way to minimize capital gains tax. If the value of your investment property is high, and you anticipate a healthy net profit from the sale, you can convert the rental into your primary residence to avoid capital gains.
However, you have to live in the home for at least 2 years before selling it as your primary residence.
The IRS allows you to avoid paying capital gains taxes on the first $250,000 of profit from the sale of your primary residence if you’re filing single, and up to $500,000 if married filing jointly.
Tax-loss harvesting involves offsetting realized gains with other investments sold at a loss.
For example, let’s say you purchased shares in an IPO that didn’t perform how you hoped. Instead of keeping the shares to see if things eventually turn around, you can sell the stocks at a loss to reduce the taxable gains from the sale of your investment property.
1031 tax deferred exchange
If you plan on selling your current rental property to buy another, you may be able to leverage a 1031 exchange.
This strategy allows investors to defer paying capital gains tax and depreciation recapture on a sold property as long as they reinvest the proceeds in a similar or “like-kind” property.
Selling when income is low
If you want to reduce the impact of capital gains taxes on profits, one strategy is to sell your rental property while your income is lower. For example, if you or your spouse is planning to quit a job, you might enter a lower income tax bracket, which would lower your capital gains tax burden.
The 2017 Tax Cuts and Jobs Act created certain areas around the U.S. that are specially designated as economically disadvantaged – these areas are called Opportunity Zones. If you purchase an investment property in one of these areas, you’ll get a step up in tax basis after 5 years. If you wait 10 years, any gains are tax free.
A cash-out refinance can be another way to lessen your tax burden. Because the IRS doesn’t consider money from a cash-out refinance as income, it’s not considered a capital gain. The best time an investor can utilize this option is when interest rates are very low.
How Do I Increase My Property Basis?
You can potentially decrease the amount of capital gain by doing home renovations and upgrades to the property, such as:
- Room additions
- Landscaping improvements
- Wiring upgrades
- Roof replacement
- New fencing
Investments into the property can pay off big time by lowering your capital gain when it’s time to sell the home.
Remember to keep extensive records of all expenses related to the upkeep and improvement of the home. You’ll need to provide receipts, invoices and statements for these expenses if you’re audited by the IRS.
Know the Facts on Capital Gains Tax
While it’s not always possible to avoid capital gains tax, there are numerous strategies to minimize the amount you’ll need to pay when selling a rental property. With a little planning, you can enjoy more gain without the pain.
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Internal Revenue Service. “Topic No. 409 Capital Gains and Losses.” Retrieved September 2022 from https://www.irs.gov/taxtopics/tc409
Internal Revenue Service. “Publication 946 (2021), How To Depreciate Property.” Retrieved September 2022 from https://www.irs.gov/publications/p946
Internal Revenue Service. “Publication 544 (2021), Sales and Other Dispositions of Assets.” Retrieved September 2022 from https://www.irs.gov/publications/p544