Investing in rental properties can supply investors with steady revenue streams that cover the mortgage while supplying some extra profits each month. And when such properties are ultimately sold, investors stand to enjoy substantial windfalls. But these selling events can trigger significant long-term capital gains tax liabilities. Case in point: in 2020, that tax rate is 15% if you're married filing jointly with taxable income between $78,750 and $488,850. And if your income is $488,851 or more, the capital gains rate spikes to 20%.
- Selling rental properties can earn investors immense profits, but may result in significant capital gains tax burdens.
- The capital gains tax rate is 15% if you're married filing jointly with taxable income between $78,750 and $488,850.
- If your income is $488,851 or more, the capital gains rate spikes to 20%.
- There are various methods of reducing capital gains tax, including tax-loss harvesting, using Section 1031 of the tax code, and converting your rental property into your primary place of residence.
For a married couple filing jointly with a taxable income of $480,000 and capital gains of $100,000, taxes on those rental-property profits would amount to $15,000. Fortunately, there are ways of minimizing this capital gains tax bite. This article explains three of the most effective ones.
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 a rental property sale
Tax-loss harvesting describes the process of reducing tax exposure when selling a rental property by pairing the gains from the sale with the loss from another investment. 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, an investor who made $50,000 from the sale of a rental apartment, who lost $75,000 in the stock market, can offset the full $50,000 in capital gains.
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 rental property sales in new real estate
What You Get: The ability to defer some or all taxes on the capital gain
Real estate investors can defer paying capital gains taxes using Section 1031 of the tax code, which lets them sell a rental property while purchasing a “like-kind” property, and pay taxes only after the exchange is made. Legally speaking, the term “like-kind” is broadly defined. An investor need not swap out one condo for another or trade one business for another. As long as both properties in question are income-generating rental units, they're fair game. But timing is key, where investors have just 45 days from the date of a property sale to identify potential replacement properties, which they must formally close on within 180 days. And if a tax return is due before that 180-day period, investors must close even sooner. Those who miss the deadline must pay full taxes on the sale of the original rental property.
Turn Your Rental Property into Your Primary Residence
What It Is: Conversion of rental property into a primary residence
Who It’s For: Anyone able to convert a rental property into their primary residence
What You Get: The ability to exclude as much as $500,000 in capital gains from taxes
Selling a home you live in is more tax beneficial than unloading a rental property for a profit. For this reason, some investors choose to convert rental properties into their primary residences. Specifically, IRS Section 121 lets people exclude up to $250,000 of the profits from the sale of their primary residence if they're single and up to $500,000 if they're married filing jointly. To qualify, investors must own their homes for at least five years and must have lived in them for at least two of those five years. The deduction amount depends on how long the property was used as a rental versus its use as a primary residence.
For example, let's assume you bought a house five years ago for $200,000 and rented it out for the first three years, before moving in two years ago. If you then sold the house for $300,000, you will have realized $100,000 in capital gains. But but you may deduct two-fifths (40%) of that amount since you lived in the home two out of five years. The remaining $60,000 in profits will be subject to capital gains taxes.
Tax Deductions For Rental Property Owners
The Bottom Line
Capital gains taxes can take a sizable chunk of profits from your rental property sales, to the tune of 15% or 20% of your take. Fortunately, capital gains tax avoidance and deferment strategies can help ease that burden.