How To Prevent A Tax Hit When Selling A Rental Property

Rental property ownership has its perks. Done right, you can get a reoccurring revenue stream, your mortgage covered and a profit each month. Not to mention a windfall when you decide to sell.  (See also: Top 10 Features Of a Profitable Rental Property.)

But that income-generating machine can cost you if and when you sell. After all Uncle Sam is going to want a cut of it in the form of capital gains taxes. Capital gains taxes come whenever you sell an asset for a profit. For 2015 and 2016, the capital gains tax rate is 15% for people who fall into the 25%, 33% and 35% income tax brackets. People in the 39.6% tax bracket pay 20%. That could be a pretty significant hit if you are realizing a decent sized profit. Let’s say you are making $100,000 on the sale. You’ll be on the hook for $15,000 in taxes. While taxes are a necessary evil, there are ways to reduce the burden when selling a rental property.

Offset Gains With Losses

An effective way of reducing 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. Called tax loss harvesting, many people employ this strategy at the end 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 Uncle Sam. Let’s say you made $50,000 off the sale of a rental apartment, but you took a bath in the stock market and lost $75,000. You can offset $50,000, making the profit from the sale of the rental property a wash. (See also: Tax-Loss Harvesting: Reduce Investment Losses.)

Take Advantage of Section 1031 of the Tax Code

Real estate investors who aren’t aiming to cash out can avoid paying capital gains taxes thanks to Section 1031 of the tax code. The IRS lets investors sell an investment, in this case a rental property, and take the proceeds of the sale and reinvest it without having to pay taxes on the gains. Under the rule the exchange can include like-kind property exclusively, or it can include like-kind property as well as cash, liabilities and property that are not like-kind. In the case of the latter, you could trigger a capital gains event in the year the exchange was completed. 

With an exchange, the simplest way to avoid paying taxes is to swap one property for another. In a more complicated strategy called deferred exchanges, you can sell a property and then acquire one or more other like-kind replacement properties. In order for it to qualify for a deferred exchange, the sale of one property and the acquisition of another must be dependent parts of the transaction. (See also: 10 Things To Know About 1031 Exchanges.)

While the swap has to be like-kind under IRS rules, that doesn’t mean you have to swap one condo for another. You can do an exchange of a condo for a store front or for a three-bedroom house as long as both are real property and are located in the U.S. Keep in mind that the property has to be for rental purposes and must have generated income. Property that you use mainly for personal use like a second home or vacation property doesn't count in an exchange.

When it comes to taking advantage of Section 1031 of the tax code, you must be mindful of the timing of the transactions. Investors have 45 days from the date of the sale to identity potential replacement properties. Within 180 days, you must close on the exchange property. If your tax return is due before that 180-day period, you have to 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

Selling a home you live in is going to have 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. Consider this: single people selling a home they live in can exclude up to $250,000 of the profits. That increases to $500,000 for married couples. In order for the IRS to view the home as your primary residence, you have to have owned it for five years and lived in it for at least two years. Keep in mind how much of the deduction you will get depends on how long it was used as a rental property. (See also: Avoid Capital Gains Tax On Your Home Sale.)

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, various strategies exist to avoid paying capital gains tax. Without them, capital gains can cost you as much as 15% or 20% of your profit, depending on what tax bracket you fall into.