How to lower capital gains tax on rental property sales

When you sell a rental property, you typically pay capital gains taxes on any profit from the sale. Fortunately, there are strategies you can use to help reduce your tax liability.

At Rocket Mortgage®, we believe everyone should have access to real estate resources, whether you’re buying or selling a home, rental, or investment property. That’s why we’re here to explain how capital gains taxes work on rental properties and share ways you might be able to keep more of your profits. It’s always a good idea to consult a tax advisor to understand how the capital gains rules apply to your specific situation.

What are capital gains on rental properties?

When you sell an investment, you may owe capital gains tax on profit, which is defined as the difference between what you bought it for and what you sold it for. In other words, the taxable gain is the profit after any adjustments. The same tax rules apply to rental properties.

For example, if you bought a residential rental property 10 years ago for $100,000 and sold it for $150,000, you’d likely owe capital gains tax on the $50,000 profit.

If you're selling your primary residence, you can exclude up to $250,000 of profit from capital gains taxes if your filing status is single, or up to $500,000 if you're married and filing jointly.

Short-term capital gains

In general, how much you pay in capital gains tax depends on how long it’s been since buying your rental house. If you sell an asset you’ve owned for one year or less, the IRS considers the profit a short-term capital gain. If you’ve owned it for more than a year, it’s treated as a long-term capital gain, and you’ll pay a lower tax rate.

Short-term capital gains are taxed like income, using your federal tax bracket, which ranges from 10% to 37%.

Here’s an example:

Let’s say you bought and sold a rental property within the same year and earned a $50,000 profit. If your regular income is $190,000 and you file taxes as a single filer, that puts you in the 32% tax bracket. Adding the $50,000 gain could push a portion of your income into the next bracket, which is 35%. This means part of your profit may be taxed at a higher rate than your ordinary income tax rate.

You can view the IRS marginal income tax rates here.

Long-term capital gains

Long-term capital gains apply when you sell an asset you’ve owned for more than a year. These gains are taxed at reduced rates – 0%, 15%, or 20% – depending on your taxable income. By holding a property for more than a year, you might be able to lower your tax liability.

How to avoid capital gains tax on rental property

Now that you have a basic understanding of capital gains taxes, let’s look at a few strategies that could help reduce what you owe after selling a rental or investment property.

Before moving forward with any of these approaches, it’s important to consult with a tax professional who can help you evaluate the best options for your situation.

Convert the property to your primary residence

One option is to convert your rental into your primary residence before selling it. According to the Internal Revenue Service, this move could reduce or eliminate capital gains taxes. However, you must meet what the IRS calls the ownership and use test to qualify, which includes:

• You've used the home as your primary residence for at least 2 of those 5 years.
• You haven't claimed the capital gains tax exclusion on another home sale within the last 2 years.

If you or your spouse serve in the military, Foreign Service, or intelligence community and are away on official duty for more than 90 days, you may be able to pause the 5-year rule for up to 10 years.

Use a 1031 exchange

A 1031 exchange, also referred to as a like-kind exchange, lets you defer capital gains taxes when you sell a rental property. The caveat is that you must reinvest the proceeds into a similar investment property. When done correctly, you can postpone paying capital gains taxes indefinitely.

Invest in an opportunity zone

If you’ve been in the real estate game for a while and are staring down a big capital gains tax hit, another route to consider is reinvesting your profits into a qualified opportunity zone.

Opportunity zones encourage long-term investments by offering investors tax advantages. After 5 years, you’ll receive a step-up in basis, which can reduce the amount of gain that’s taxed. If you hold the new investment for at least 10 years, any additional gains can be completely tax-free.

Harvest your tax losses

If you have other investments, you can use any losses to help cancel out the capital gains tax from selling your rental property. This strategy is known as tax-loss harvesting, and under it, you can sell underperforming assets to offset your capital gains. You also can use up to $3,000 in excess losses each year ($1,500 if you’re married and filing separately) to reduce your taxable income.

Own the property longer

Timing matters when it comes to capital gains taxes. If you sell a rental property you’ve owned for less than a year, your profit is taxed at the same rate as your income. But if you hold the property for more than a year before selling, you’ll pay a lower rate with capital gains tax, or maybe no tax at all.

Here’s a quick example:

Let’s say you buy a rental property for $200,000 and sell it just a few months later for $250,000. That $50,000 profit is considered short-term and taxed as ordinary income. If you’re in the 22% tax bracket, you’d owe $11,000 in taxes.

But if you hold the property for more than a year before selling, that same $50,000 profit would be taxed as a long-term capital gain. At a 15% rate, you’d owe just $7,500, which could save you $3,500.

How to reduce your capital gains tax liability

The strategies above are typically more advanced. So, even if none of them seem like a viable option for your situation, there are a few straightforward moves that could also help you lower your capital gains tax liability.

Deduct your property’s depreciation

The IRS assumes rental properties decrease in value over time, even if they’re actually gaining value. This is known as depreciation, and it allows rental property owners to gradually deduct the cost of the property itself, as well as any improvements made during ownership.

For example, if you buy a rental, you could choose not to deduct the full cost in the first year. Instead, you would write off a small portion of the cost each year. Typically, the IRS lets you deduct up to about 3.6% annually and claim depreciation for up to 27.5 years, which may help you save on taxes each year.

This deduction reduces your taxable rental income and could even push you into a lower tax bracket. Over time, you may be able to recover the full value of the property through these annual depreciation deductions.

One thing to keep in mind is that while depreciation can lower your taxes during ownership, it may increase your tax bill when you sell the rental property. That’s because the IRS expects you to “pay back” some of those tax savings through something called depreciation recapture, which is taxed at a different rate than regular capital gains. So, even though depreciation is a benefit while you own the property, it’s important to plan for the potential tax impact when you eventually sell.

Deduct qualified expenses

Many of the costs that come with managing and owning a rental property can help reduce your tax bill.

You can deduct a wide range of qualified expenses, such as:

• Mortgage interest payments. If you're financing your rental, the interest portion of your mortgage payments is typically tax-deductible.
• Maintenance. Costs associated with maintaining your rental, such as replacing broken light fixtures, may be deductible expenses.
• Insurance. Landlord insurance and rental property insurance may be tax-deductible expenses.
• Travel. If you keep a detailed record of your travel, you may be able to deduct travel and mileage costs if you must travel to manage your rental.
• Professional services. Fees paid to accountants, property managers, attorneys, or even leasing agents can usually be deducted as a business expense, if they’re directly tied to the operation of your rental.
• Eviction-related expenses. If you must evict tenants, any legal fees, court costs, or locksmith charges may be tax-deductible.

Increase your property basis

Simply put, your property’s basis is what you’ve invested in it for tax purposes. Your basis plays a significant role in how much you’ll pay in capital gains tax when you sell it.

To calculate your basis, start with the purchase price of the property. Then add the cost of any capital improvements you’ve made over the years, which can include things like a new roof, room additions, or kitchen upgrades. From there, subtract any depreciation you’ve claimed or losses from events like a fire or theft.

A higher basis essentially means a lower capital gain, which may help you lower your tax liability.

Let’s say you bought a rental for $100,000 and sold it 10 years later for $300,000. At first glance, it appears to be a $200,000 capital gain. However, if you invested $125,000 in documented improvements over the years, your adjusted basis increases to $225,000. That brings your taxable gain down to $75,000 instead.

FAQ

Here are answers to common questions about capital gains tax on rental properties.

Can I avoid paying capital gains tax on rental properties?

It’s possible to avoid or delay capital gains tax through a 1031 exchange, converting the property to your primary residence, or offsetting gains with losses from other investments. However, when you eventually sell the asset for good, you’ll likely have to pay at least some capital gains taxes.

How much will I have to pay if I sell my rental property?

The amount you pay ultimately depends on key factors, such as your profit from the sale, the length of time you’ve owned the rental, and your income bracket. If you’ve owned the property for more than a year, your profit is usually categorized as a long-term capital gain. These gains are typically taxed at 0%, 15%, or 20%, depending on your income.

Are there ways I can reduce what I owe when I sell?

You may be able to reduce what you owe by increasing your adjusted basis through documented improvements, using tax-loss harvesting to offset gains, or timing the sale for a year when your income is lower.

When is paying a short-term capital gains tax a good strategy?

While it’s usually better to aim for long-term capital gains, paying short-term capital gains tax can sometimes be advantageous. For example, if your income is temporarily low, the property isn’t expected to appreciate, or the cost and risk of holding it longer outweigh the tax savings.

The bottom line: You can pay less in capital gains tax 

Paying capital gains tax is a common requirement when selling most assets, including rental properties. While you may not be able to avoid it entirely, there are ways to reduce what you owe. Strategies such as converting your rental property to a primary residence or using tax-loss harvesting can all help. You can also lower your tax bill by claiming deductions and increasing your adjusted basis with documented improvements. It’s always best to speak with a qualified tax advisor. They can help you understand your options and make a plan that works for your situation. 

Want to learn more? Check out more helpful guides and resources at Rocket Mortgage Learn to keep building your real estate know-how.