Keeping detailed records of your finances across your investment portfolio will ensure you pay the correct capital gains tax.
Capital gains tax is a tax on profit made from the sale of an asset. This asset can be anything, a piece of art, expensive jewelry, a classic car, or, in this scenario your property.
Because of the nature of real estate as an investment capital gains tax on rental property can be large. When you sell your property then, you need to make sure that you calculate the correct amount of capital gains, taking into account depreciation and your adjusted cost basis amongst other things, and report it accurately at the end of the year as taxable income to the IRS. This income will then be taxed at either the long-term or short-term capital gains rate depending on how long you have owned the asset. Long-term capital gains rates are more favorable than short-term gains rates.
In this article, we take a look at the current capital gains tax rates, how you calculate the capital gains on rental property, the effect of depreciation, and explore some strategies you can use to avoid paying capital gains tax on the sale of your rental property.
Please note, calculating capital gains on rental property can be complex. So, to ensure you are staying on the right side of the law and paying the correct amount of tax you will want to consult with a licensed professional to discuss the best course of action.
The IRS allows $250,000 of tax-free profit on a primary residence. What this means, in a simplified sense, is if you bought your primary residence for $300,000 in 2010, lived in it for 8 years, and then sold it in 2018 for $550,000, you wouldn’t have to pay any capital gains tax. This amount is doubled if you are married.
For capital gains on rental property, however, the amount of tax you have to pay depends on your personal tax bracket (see below). There is no allowance for investment properties meaning tax must be paid on all profits made after the sale of the investment property.
Another thing that should be taken into consideration is the favorable nature of long-term capital gains taxes compared to short-term capital gains. For an asset to qualify for the long-term gains rate, you will need to have held it for longer than 12 months.
Short-term capital gains are taxed as ordinary income according to federal income tax brackets.
The IRS allows you to depreciate the value of a rental property over a 27.5 year period to account for wear and tear that the property might go through. Note that the land itself is not depreciable. The depreciated amount can then be claimed back against the amount of taxes owed for that year.
However, the IRS will then reclaim some of the value of the depreciated amount when it comes time to sell the rental property. Through this depreciation recapture under section 1250, the IRS partially reclaims the deducted value of the property.
Essentially you will need to pay capital gains tax on the depreciated value at a higher tax rate. The IRS calculates the total deduced amount as being depreciated even if you didn’t claim depreciation on the property – so make sure you do.
This means that the IRS whilst the capital gains on your rental property may qualify for the favorable long-term capital gains rate (at a maximum of 20%), the part related to depreciation is taxed instead at a higher rate of up to 25%.
The easiest way to explain how this works is to work through a quick example.
You buy a property for $340,000 with the land worth $65,000 (land can’t be depreciated), and the property itself worth $275,000. You make no deductible improvements to the property during the time you own it meaning the cost basis doesn’t need adjusting. After 10 years you sell the property for $500,000.
For further information on how this applies to you consult with a licensed professional.
The long-term capital gain or loss amount is determined by the difference in value between the sale price and the purchase price. This figure is either the net profit or loss that the investor experienced when selling the asset.
Short-term capital gains or losses are determined by the net profit or loss an investor experienced on the sale of an investment property that was owned for less than 12 months. The Internal Revenue Service (IRS) assigns a lower tax rate to long-term capital gains than short-term capital gains making it advantageous to hold and rent your investment property long-term.
A taxpayer will need to report the total of capital gains on the rental property earned for the year when they file their annual tax returns because the IRS will treat these short-term capital gains earnings as taxable income. Long-term capital gains are taxed at a lower rate, as outlined in the table above, and ranges from 0% to 20%, depending on the tax bracket that the taxpayer is in.
When it comes to capital losses, both short-term and long-term losses are treated the same. Taxpayers can claim these losses against any long-term gains they may have experienced during the filing period.
Real estate investors are often looking for the next investment and unless you are looking to cash out you can put off paying capital gains tax on rental property thanks to Section 1031.
A 1031 exchange lets you sell your rental property, purchase a “like-kind” property, and defer paying taxes at the time the exchange is made. You can execute 1031 exchanges as many times as you want, but when you eventually make a profit, taxes will be due.
The simplest way to defer taxes is to swap one property for another. A more complicated strategy called a deferred exchange lets you sell a property and hold the funds in trust until you are able to acquire one or more other like-kind replacement properties.
In this context, like-kind means another rental property. You cannot for example 1031 exchange a rental for a new holiday home. The main stipulation is that the property must be used for rental purposes and generate income.
You get 45 days from the date of the sale to identify potential replacement properties and you must close on the replacement property (or properties) within 180 days. If your tax return is due before that 180-day period, you must close sooner.
As we mentioned at the beginning of this article when you sell your primary residence the first $250,000 ($500,000 if you’re married) of profit made through capital gains is tax-free. This is why some people convert rental properties into their primary residences.
To qualify as a primary residence you must have:
For example, you buy a property and live in it for two years and rent it out for three. After five years of ownership, you sell. You would then have to pay capital gains taxes on 3/5ths of the profit generated from the sale of the property as you lived in it for 2/5ths of the time.
A final way you can reduce your taxable income when you sell a property is to offset losses from another area of your investments against the profits of the sale of your property.
For example, you make $100,000 of capital gains on the sale of your property. However, you also invest in a new property that year and that property makes a loss of $20,000 for that taxable year. You could offset this loss against your profits so that your taxable capital gains are only $80,000. You can also offset losses from things like stocks.
As with everything, it’s incredibly important that you keep detailed records of your finances across your investment portfolio. This goes for more than just the single investment asset that you are selling. Keeping good records may actually help reduce the capital gains tax on your rental property. For example, offsetting through losses which we covered above.
When you do sell an investment property you will want to track your capital gains and safely store your historical rental data for future tax purposes and better oversight of – even if you delay paying through a 1031.
The best way to show that you’ve sold your property in the Landlord Studio system is to archive it. This allows you to retain and freely access all your property’s historical data but shows you are no longer renting it out. You can do this by navigating to the property and then select edit property. Scroll to the bottom and under the option “Archive Property” select “yes”. I’ve attached a help article with screenshots.
You can also track the capital gains on rental property through the Landlord Studio software using the valuation feature paired with our net worth report. The valuation allows you to enter the property purchase price and its current valuation. Then you can run a net worth report for one or all of your properties to gain a clear oversight into your portfolio’s current net worth or at the sale of investment property to calculate capital gains for tax purposes.
Landlord Studio allows you to keep detailed records of your income and expenses, as well as track, things like depreciation as well as your property value.
“Track income and expenses, screen tenants, set automatic reminders, and more with Landlord Studio.”
Capital gains tax on the sale of a rental property can take a hefty chunk out of your profits, especially if you are unprepared. However, there are several ways, detailed above, to minimize this capital gains tax hit.
Everyone’s scenario is different, so it’s always worth discussing your options with your accountant to ensure you are accurately calculating the capital gains tax on your rental property and you don’t end up overpaying at the end of the year.
Thanks for reading, we hope you found this blog interesting. However, do note that the purposes of this article are for general information. We are not licensed financial or legal professionals and as such nothing in this article should be understood to be financial or legal advice. If you require financial or legal assistance please seek the help of a competent professional.