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ContinueKeeping 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.
When you sell a capital asset, like shares of a publicly traded company or a rental property, for a higher amount than what you initially paid, you incur a capital gains tax.
For example, you purchase a rental property in 2010 for $250,000 and sell it in 2020 for $350,000 you would be liable to pay capital gains tax (and potentially state tax based on your location) on the difference, eg, $100,000. The amount of that capital gains tax is dependent on your income tax bracket.
This scenario also applies to stocks and other assets such as art, jewelry and luxury vehicles.
Understanding the various factors influencing capital gains on rental properties can assist in minimizing or even eliminating the tax liability upon selling.
There are two different kinds of capital gains, short term and long term capital gains. Short term capital gains refers to when an asset, like a rental property, is sold for a gain within the initial year of acquisition. This is generally the case with investors using the fix-and-flip investment strategy. The short-term capital gains tax mirrors the tax structure for regular income, ranging from 10% to 37%. The tax rate increases as your taxable income rises.
However, if you hold the asset for longer than one year you will instead be liable for the long-term capital gains tax rate. Taxation on long-term capital gains varies between 0%, 15%, or 20%, depending on your taxable income.
The IRS allows $250,000 of tax-free profit on a primary residence ($500,000 if filing jointly). 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 does not apply to investment properties, however. Capital gains on rental property are taxed dependant on your personal tax bracket (see below). There is no tax free allowance for investment properties meaning tax must be paid on any and all profits made after the sale of the 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.
The IRS will claim depreciation recapture even if you didn’t claim depreciation on the property – so make sure you do.
A property's depreciation impacts it's cost basis. Essentially, lowering the value of the property over what the IRS deems it's useful life. What this means is that if you sell the property for more than the adjust cost basis (taking the deprciation deduction into account), the profit or difference between the sale price and cost basis will be treated as a gain. It's not quite as simple as treating all of it as long term capital gains however.
Whilst the capital gains on your rental property may qualify for the favorable long-term capital gains rate (of up to 20%), the part related to depreciation is taxed at a higher rate of up to 25%.
The easiest way to explain how this works is to work through an 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 major improvements to the property during the time you own it. After 10 years you sell the property for $500,000.
This is then split into two different taxable portions,
This article gives a further detailed explanation of Depreciation Recapture
For further information on how this may apply to your situation consult with a licensed professional.
There are ways to reduce or even eliminate your capital gains tax liability. Before undertaking any of these actions, you should consult with a trusted tax advisor to make sure all contingencies are considered.
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.
Related: What Biden’s Tax Proposal May Mean For The 1031 Exchange
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:
A further note is that the amount of your deduction depends on how long the property was used for rental versus as a primary residence.
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. This is called tax loss harvesting
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.
Learn more about Tax Deductible Expenses for Landlords.
As mentioned above, short-term capital gains are taxed at a higher rate than long-term gains. As such, if you’re thinking of selling your property within that first year, instead consider holding onto it for a little while longer to qualify for the more favorable long-term capital gains tax rate. This is an easy way to reduce the capital gains taxes owed.
The property basis represents your capital investment in the asset for tax purposes. To calculate the basis, start by noting the original investment cost. Then, include the expenses for significant improvements, like additions or upgrades. Subtract any amounts allowed for depreciation, casualty, and theft losses. Making various capital improvements over time can elevate the basis.
Example: If you purchase a property for $250,000 and sell it ten years later for $350,000 the resulting $100,000 gain qualifies as a long-term capital gain. However, with documented evidence of $40,000 in capital improvements, your effective capital investment, the cost basis of the property, becomes $290,000, which would reduce the taxable capital gain to $60,000.
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.
There are several ways you can reduce or defer paying capital gains tax on a rental property. As described in more detail above, these include converting the property to your primary residence, harvesting tax losses from other assets you own, or rolling your gains into another investment through a 1031 exchange. Depending on your personal and financial situation, some or none of these options may be available to you.
If you sell the property for more than you paid for it, you will likely have to pay some tax on the difference. If you owned the property for less than a year, your profit is deemed a short-term capital gain and is usually taxed at the same rate as your other income. If it’s more than a year, you have a long-term capital gain that is taxed at 0%, 15% or 20% depending on your taxable income. Your financial advisor and tax advisor may have ideas for ways to reduce or eliminate your capital gains tax liability.
As discussed above in detail, with some good financial strategy there are ways you can reduce the amount of capital gains tax you’ll pay after selling. These include deductions for depreciation and any qualified expenses you’ve incurred while owning the property, as well as boosting the property’s basis with documentation of any capital improvements you’ve made to it.
People often try to avoid paying short-term capital gains, which are taxed at a higher rate than long-term, by holding on to the property for longer than 1 year. While short-term capital gains can increase your tax bill, it might be the best strategy to sell and pay them when the gains are worth it.
To calculate your gain, subtract the adjusted basis of your property at the time of sale from the sales price your rental property sold for, including sales expenses such as legal
A few options to legally avoid paying capital gains tax on investment property include buying your property with a retirement account, converting the property from an investment property to a primary residence, utilizing tax harvesting, and using Section 1031 of the IRS code for deferring taxes.
While rental income is taxed as ordinary income, you can reduce that income and lower your tax bill by deducting allowable expenses.
You can sell your primary residence and avoid paying capital gains taxes on the first $250,000 of your profits if your tax-filing status is single, and up to $500,000 if married and filing jointly. The exemption is only available once every two years. But it can, in effect, render the capital gains tax moot.
Since the tax break for over 55s selling property was dropped in 1997, there is no capital gains tax exemption for seniors. This means right now, the law doesn't allow for any exemptions based on your age. Whether you're 65 or 95, seniors must pay capital gains tax where it's due.
When you inherit property, you may be subject to capital gains tax if you later sell the inherited property. However, the tax implications can vary depending on the jurisdiction and the laws in place at the time of inheritance. In some situations, the tax basis of the inherited property is "stepped up" to its fair market value at the time of the original owner's death. This step-up in basis can reduce or eliminate capital gains tax when the property is sold.
When you sell a rental property, the accumulated depreciation on that property can have tax implications. Depreciation is a tax deduction that property owners can take each year to account for the wear and tear on the property. However, when you sell the rental property, you may be required to recapture some or all of the depreciation that you claimed as a deduction over the years.
The recaptured depreciation is taxed at a specific rate, which is currently 25% for federal income tax purposes. This recapture is known as "depreciation recapture." The remaining gain from the sale of the property, which is not due to depreciation recapture, is treated as a capital gain.
The cost basis for selling a rental property is the original purchase price of the property, plus any additional costs incurred during the acquisition, such as closing costs and legal fees. This initial cost basis is then adjusted over time to account for various factors.
Adjustments to the cost basis may include:
The adjusted cost basis is subtracted from the sale proceeds to determine the capital gain or loss on the sale of the rental property. It's important to maintain accurate records of all transactions and expenses related to the property to calculate the correct cost basis.
To calculate the basis for selling a rental property, you need to consider the following elements:
The formula for calculating the adjusted basis is:
Adjusted Basis=Original Purchase Price+Improvements/Additions−Depreciation+Deductible Expenses
Adjusted Basis=Original Purchase Price+Improvements/Additions−Depreciation+Deductible Expenses
Once you have the adjusted basis, you can calculate the capital gain or loss on the sale by subtracting the adjusted basis from the sale proceeds.
Yes, capital gains are considered a form of income for tax purposes.
Capital gains are categorized as either short-term or long-term, depending on how long you held the asset before selling it. Short-term capital gains result from the sale of assets held for one year or less, while long-term capital gains arise from the sale of assets held for more than one year.
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