What Are Capital Gains Taxes And How Do They Work With Rental Property?

America has a progressive federal income tax system, meaning those who earn more pay a higher percentage of their income as tax, while those who earn less pay less. But many people don’t realize that when they reinvest after-tax money in things like stocks or real estate, and that investment generates a profit, the profit is also subject to taxation. This is called a capital gains tax, and like everything else having to do with the tax code, it only gets more complicated from there.

What Are Capital Gains On Rental Properties?

You pay a capital gains tax when you sell a capital asset, such as shares of a publicly traded company or a rental property that you own, for more than you paid for it – plus or minus certain adjustments. For example, if you purchased stock in a company 5 years ago for $10,000 and sold it this year for $20,000, the $10,000 profit would be subject to federal capital gains tax and possibly state tax as well, depending on where you live.

The same principle applies to your rental property, such as a second house that you rent to others. Understanding how different factors effect capital gains on rental properties can help you mitigate or even eliminate the tax you’ll pay after you sell.

Short-Term Capital Gains

Short-term capital gains are the profits realized from the sale of an asset, such as a rental property, within the first year after you first acquired it. The short-term capital gains tax is similar to the tax on your regular income, between 10% and 37% – the rate gets higher as your taxable income gets higher.

Long-Term Capital Gains

Long-term capital gains are profits you realize from the sale of an asset you’ve held for more than 1 year. Long-term capital gains are taxed at 0%, 15% or 20% depending on your taxable income.

How To Avoid Capital Gains Taxes On The Sale Of Rental Property

There are ways to reduce or even eliminate your tax liability on the capital gains you make from the sale of a rental property. Before undertaking any of these actions, you should consult with a trusted tax advisor to make sure all contingencies are considered. Here are your options.

Convert The Property To Your Primary Residence

Section 121 of the Internal Revenue Code allows you to reduce or eliminate capital gains tax by converting your rental property to your primary residence before selling if:

• You own the home for at least 2 of the preceding 5 years before selling it
• You use the home as your primary residence for at least 2 of the previous 5 years
• You have no excluded capital gains tax from any other sale within the last 2 years

Use A 1031 Exchange

Many real estate investors engage in 1031 (like-kind) exchanges. In a 1031 exchange, a real estate investor sells their current property but then rolls the proceeds into a new investment opportunity and postpones their capital gains taxes indefinitely.

Another alternative available to longtime real estate investors with large capital gains tax liabilities is to transfer those assets into an opportunity zone. Investors begin to enjoy a step up in basis after 5 years. After 10 years, the gains become tax-free.

Harvest Your Tax Losses

If you have an investment portfolio in addition to your rental property, you might be able to use losses in the portfolio to offset your capital gains tax when you sell the property. The losses reduce your overall taxable capital gains and potentially offset some of your taxable income. You can then use the money from the sale of the underperforming securities to invest in a different security. A good financial advisor will make an annual assessment of your portfolio and determine if there is a viable tax loss harvesting strategy available.

Own The Property Longer

If you own the property for less than a year before selling, any gain is considered a short-term capital gain, which is taxed like your regular income. If you owned the property for more than a year, the profit is considered a long-term capital gain, which is generally lower than income tax and may even be zero.

How To Reduce Your Capital Gains Tax Liability

There are lots of ways you can reduce your tax liability on capital gains realized from sale of a rental property. These will require you keep all records from the original purchase of the property and a detailed accounting of all expenses you incurred related to the property. You’ll also need a good tax advisor.

Deduct Your Property’s Depreciation

Rental property depreciation is a basic accounting principle that allows you to deduct the cost of a rental property over a set period of time. The IRS assumes a rental property will lose a certain amount of value every year (typically 3.6%). For as long as you own the property, this loss, also known as depreciation, can be subtracted from your taxable income every year. This, in turn, can lower your taxes and may even drop you into a lower tax bracket. If you own a rental property, the federal government allows you to claim the depreciation of the property every year for 27.5 years.

Deduct Qualified Expenses

You can earn tax deductions for all qualified expenses on your property, including mortgage interest payments, maintenance, insurance, travel, professional services, eviction-related expenses and more.

Increase Your Property Basis

The property basis is the amount of your capital investment in the asset for tax purposes. To determine the basis of your property, begin by noting the cost of the original investment that you made in it. Next, add in the cost of major improvements (for example, additions or upgrades). Then, subtract any amounts allowed via depreciation or casualty and theft losses. There are any number of capital improvements you can make over time to bring up the basis.

Here's an example of how increased basis reduces your tax. Say you buy a property for $100,000, keep it for 10 years and are about to sell it for $300,000. That would qualify as a long-term capital gain of $200,000. However, if you have detailed, documented evidence that you have made $125,000 in capital improvements to the property, your capital investment is effectively $225,000. Your capital gain is now reduced to $75,000.