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Accounting

All About Capital Gains Tax on Rental Properties

Capital gains tax is a tax on any profits made from the sale of an asset. This asset can be anything, a piece of art, expensive jewellery, a classic car or, in this scenario your property.

When you sell an asset for profit the money made from the sale needs to be reported that 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 been in possession of the asset. Long term capital gains rates are more favorable than short term gains rates. 

Often it’s a little more complex than this. 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 licenced professional to discuss the best course of action.

The Importance of Keeping Excellent Records

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 your capital gains tax through things like offsetting through losses which we talk about later in this article. 

When it comes to tracking your properties financials, Landlord Studio allows you to keep detailed records of your income and expenses, as well as track, things like depreciation as well as your properties value. 

And you can instantly generate professional reports, like our profit and loss or Schedule E report. Gain a clear overview of your property portfolio, fast.

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Capital gains tax on your Investment Property

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 a rental property, however, the amount of capital gains taxes 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 favourable 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. 

Long Term Capital Gains Tax Rates for 2020

Long Term Capital Gains Rate Single Filers Filing Jointly (Married Filers)
0% Income: $0.00 to $39,375 Income: $0-$80,000
15% Income: $40,000-$441,450 Income: $80,000-$496,600
120% Income: Over $441,550 Income: Over $496,600

Short-term capital gains are taxed as ordinary income according to federal income tax brackets.

capital gains taxes

Depreciation Recapture

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.

When it comes time to sell the property under depreciation recapture section 1250, the IRS partially reclaims the deducted value of the property.

How this works

The IRS deduct the depreciated amount from the capital gains and charge capital; gains taxes at a higher rate against this amount. Meaning, whilst your capital gains 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. After 10 years you sell the property for $500,000.

  • The yearly depreciation deductible works out to be $275,000 / 27.5 = $10,000 
  • The overall amount the property is depreciated over those 10 years would be $10,000 x 10 years = $100,000.
  • The adjusted cost basis then is (purchase price) $340,000 – (depreciation) $100,000 = $240,000
  • The capital gains on this property $500,000 – $240,000 = $260,000
  • This is then split into two different taxable portions, the capital gains ($260,000 – $100,000 = $160,000) which is taxed at the favourable long term gain rates and the depreciation recapture ($100,000) which is taxed at a max of 25%. 

This article gives a further detailed explanation of Depreciation Recapture

For further information on how this applies to you consult with a licensed professional.

discussing data

Avoiding Capital Gains Taxes

Long term vs. short term CGT rates

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 when selling an asset 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.

A taxpayer will need to report the total of their capital gains 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, which as of 2019 ranged from 0% to 20%, depending on the tax bracket that the taxpayer is in.

When it comes to capital gains 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.

1031 exchange

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 taxes 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 take 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 then 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. 

Here’s a good article that goes into more detail about what a 1031 exchange is and how to pull one off.

Turn the property into your primary residence

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. Which is why some people convert rental properties into their primary residences.

To qualify as a primary residence you must have:

  • Owned the property for at least 5 years;
  • Lived in it for at least 2 of those years.

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.

Offest with losses

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 is only $80,000. You can also offset losses from things like stocks.

Learn more about Tax Deductible Expenses for Landlords.

Conclusion

Capital gains tax on the sale of a 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 tax hit.

Everyone’s scenario is different, so it’s always worth discussing your options with your accountant to make sure you take the appropriate action.

Thanks for reading, we hope you found this blog interesting. However, do note that the purposes of this article is 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 are in need of financial or legal assistance please seek the help of a competent professional.

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Ben Luxon
Ben Luxon

"Ben is an author and real estate enthusiast. His interest in all things entrepreneurial has led him to work with real estate professionals all over the world, distilling their knowledge into articles and Ebooks. His love of travelling has taken him to over 10 countries in the last year, where he has sampled the craft beer of them all."

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