Selling rental properties can earn investors immense profits, but may result in significant capital gains tax burdens. Under the current tax law, if you have owned an investment property for less than a year, your gain is taxed at your current income tax rate. Long-term investments are typically taxed as capital gains at 15% or 20% depending on your tax bracket. You'll also need to pay tax on “depreciation recapture” when you sell a long-term investment. Depreciation is a tax deduction you take annually when you own an investment property. Whether you took the depreciation write-off or not, the cumulative value of that annual deduction becomes taxable income when you sell....
Investment income from a rental property sale may look good on first glance. But if you consider the U.S. federal capital gains tax (CGT) you’ll have to pay — which can be 15%, 20% or as high as 37% — these taxes can take a sizable chunk of profits from your rental property sales.
Fortunately, there are many ways or strategies to reduce and/or defer your CGT exposure so you can keep a larger percentage of your profits.
1. Hold on to the property for more than a year before selling
When you sell a property, you’ve held for less than a year, the profit is considered to be a short-term capital gain, which can be taxed at a federal rate of up to 37%.
If you sell the same asset after holding it for over one year, the profit is classified as a long-term capital gain, which has a much lower tax rate of 0% to 20%.
Holding on to a property until it qualifies as a long-term investment could reduce your federal tax burden dramatically.
2. Converting rental property into a primary residence
You can be exempt from paying CGT when you sell a primary residence that meets certain criteria. Individuals can exclude up to $250,000 of capital gains while a married couple can exclude up to $500,000.
Under the Section 121 exclusion, you’ll have to own and use the property as your primary residence for two out of the five years immediately preceding the date of the sale. In addition, you’re only eligible if you haven’t taken a capital gains exclusion for any other property sold at least two years before this current sale.
3. Sell your property when your income is low
Your CGT rate is determined by your tax bracket, which is calculated based on your income. If you can, being strategic as to the time of sale could have a positive impact on your tax burden.
For example, if you or your spouse quit or lose a job, or if you’re about to retire – sell during a low-income year and minimize your capital gains tax rate.
4. Tax-loss selling or tax-loss harvesting
Tas loss harvesting is the process of reducing tax exposure when selling a rental property by pairing the gains from the sale with the loss from another investment. This can be a tax planning strategy if an investor is holding an investment that has lost value (an unrealized loss) and decides to sell the asset at a loss in the same year as the gain on rental property sale (a realized loss). Although this tax-minimizing tactic is primarily used to offset gains from stock investments, more and more folks are applying it to rental real estate property sales.
For example, assume an investor made $50,000 from the sale of a rental apartment in the current year. They also have an unrealized loss of $75,000 in the stock market. The investor can choose to sell off a portion of their stocks to realize a $50,000 loss in order to fully offset the $50,000 in capital gains.
5. Minimize Your net profit through records of home improvement and selling expenses
The capital gains tax on the sale of the rental property applies to the net profit, not the difference in purchase price and sale price or the Gross profit. Net profit is derived from deducting all operating expenses to the gross income/profit.
The operating expenses are all the expenses associated with renovating and selling the investment, additions or home improvements made to the property over the years (which can increase the value of the property).
Examples of the expenses associated with the sale of the property to reduce the amount of CGT you must pay are realtor commissions, inspections, origination fees, etc.
This strategy works well for a primary residence. However, real estate investors with multiple properties should check with their tax advisors or realtors to see if they’re eligible.
6. Take advantage of a 1031 Exchange
When you sell a rental property, you can roll the proceeds of the sale into a similar type of investment to avoid CGT.
This is called a 1031 exchange and it is popular among real estate investors as a strategy for building wealth.
However, the tax code is very complex and there are multiple criteria you’ll need to meet like:
- You cannot touch the proceeds from the sale of the property. The money must go directly into an escrow account.
- You have 45 days from the sale to find the next property.
- You have 180 days from the sale to close on another property
If any of those conditions isn’t met, you will have to pay the capital gains tax on the sale of your property investment. In addition, a 1031 exchange can only take place between two rental properties. For a home to be considered a rental property, certain conditions must be met.
- You must have owned the home for over two years.
- You must have rented the property for at least 14 days in each of the previous two years.
- You cannot have used the property as a vacation home for more than 14 days or 10% of the days it was rented in each of the previous two years.
The same conditions must be met on the replacement property for the first two years that you own it.
The taxes on selling rental house can get complicated, you’ll likely need to hire a professional to guide you, process the paperwork and make sure everything is properly filed. And our team at Pacific South Coast can guide you through the selling and/or investment process and be able to walk you through all options that can give you a much clearer picture of which tax strategy will be the best fit for you. You may avail on our services, and you will receive proposals from top-notch local real estate agents who are ready to work with you on your real estate needs.