Rental property ownership has its perks. If you choose the right rental property, you can receive a regular revenue stream that covers the mortgage and provides you with a respectable profit each month. When you sell the property, you may be in for a sizable windfall.
However, that income-generating machine can cost you when you sell. That’s because you will pay taxes on the capital gains (profit) when the property is sold. For 2018, the long-term capital gains tax rate is 15% if you are married filing jointly with taxable income between $77,201 and $479,000. If your income is $479,001 or more, the capital gains rate is 20%.
Selling rental property could result in a significant tax bite, depending on the profit you realize from the sale. For a married couple filing jointly with a taxable income of $480,000 and capital gains of $100,000, for example, taxes on those rental-property gains would amount to $20,000. But there are ways to reduce the burden when you sell a rental property; below are three strategies.
Offset Gains with Losses
What It Is: Tax-loss harvesting
Who It’s For: Anyone with capital losses in a given tax year
What You Get: The ability to subtract those losses from the capital gains realized from the rental property sale
An effective way to reduce your tax exposure when selling a rental property is to pair the gain from the sale with a loss in another area of your investments. This is called tax-loss harvesting. Many people employ this strategy at the end of the year to reduce the amount they owe from stock gains, but it can also be used for rental real estate property. That’s because the Internal Revenue Service lets you pair gains with losses to lower the amount you owe the government.
Say you made $50,000 off the sale of a rental apartment, but took a bath in the stock market and lost $75,000. You can offset the full $50,000 in capital gains, making the profit from the sale of the rental property a wash.
Take Advantage of Section 1031 of the Tax Code
What It Is: IRS Section 1031 “Like-kind” Exchange
Who It’s For: Anyone able to reinvest the proceeds of selling investment real estate (i.e. rental property) in new real estate
What You Get: The ability to defer some or all taxes on the capital gain
Real estate investors who aren’t aiming to cash out can put off paying capital gains taxes thanks to Section 1031 of the tax code. A Section 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. Before passage of the Tax Cuts and Jobs Act of 2017 your Section 1031 exchange could even involve certain types of personal property. Under the new law, the exchange must involve real estate.
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. The term “like-kind” has a very broad interpretation. You don’t have to swap one condo for another or one business for another. The main stipulation with property is that it must be for rental purposes and must have generated income. Your personal home, vacation home or other property do not count.
Timing is important. You have 45 days from the date of the sale to identify potential replacement properties and you must close on the replacement property within 180 days. If your tax return is due before that 180-day period, you must close sooner. Miss the deadlines and you will have to pay taxes on the sale of the original rental property.
Turn Your Rental Property into Your Primary Residence
What It Is: Conversion of rental property to a primary residence
Who It’s For: Anyone able to convert rental property to their primary residence for better tax treatment when they sell
What You Get: The ability to exclude as much as $500,000 in capital gains from taxes
Selling a home you live in has better tax benefits than unloading a rental property for a profit, which is why some people convert rental properties into their primary residence to avoid the capital gains tax hit. IRS Section 121 allows you to exclude up to $250,000 of the profits from the sale of your primary residence if you are single and up to $500,000 if you are married filing jointly. To qualify you must have owned the home for five years and lived in it for at least two years out of the five. The amount of your deduction depends on how long the property was used for rental versus as a primary residence.
Suppose, for example, you bought a house five years ago for $200,000 and rented it out for the first three years. Two years ago, you moved in and then sold the house recently for $300,000. You will have realized $100,000 in capital gains but can only deduct two-fifths (40%) of that amount since you only lived in the home two out of five years. The remaining $60,000 in capital gains will be subject to capital gains taxes.
Tax Deductions For Rental Property Owners
The Bottom Line
The capital gains tax can take a big chunk out of your profit from the sale of a real estate investment, but thankfully there are ways to get around that. Whether you engage in an exchange of one property for another, pair investment losses with gains to offset the tax hit or convert your rental into your primary residence, these strategies will help you defer or avoid paying some or all capital gains taxes. Without them, capital gains can cost you as much as 15% or 20% of your profit, depending on your taxable income.