Investing in rental properties offers many benefits, including a steady stream of passive income and the potential for your property's value to rise over time. Real estate investments are also an excellent hedge against inflation, as property prices tend to rise alongside inflation rates.
Tax benefits also attract many real estate investors. By treating your rental properties as a business, the IRS allows you to deduct certain expenses such as mortgage interest, depreciation, and property management costs.
However, selling your rental can trigger significant capital gains and tax liabilities.
- Short-term rates (for properties held less than a year) can be as high as 37%.
- Long-term rates (for properties held a year or longer) can reach up to 20%.[1]
For example, if you sell a property for a net capital gain of $50,000, you could owe between $10,000 and $18,500 in taxes, depending on your holding period, tax rate, filing status, and total taxable income.
The good news is that you can avoid these taxes with a few strategic moves.
Ways to avoid (or defer) taxes on a rental property sale
Your financial advisor can work with you to lower your tax liability based on your unique situation. Here are some general tips to keep more profits from your rental property sale.
Conduct a 1031 Exchange
Through a 1031 exchange, investors can indefinitely defer capital gains taxes by reinvesting the profit into a similar or “like-kind” property.[1] This tactic requires you to:
- Use a Qualified Intermediary (QI) to administer and document the exchange.
- Reinvest 100% of the net sale proceeds into the replacement properties.
- Purchase replacement properties of equal or greater value as the sold property.
- Identify replacement properties within 45 days of closing escrow on the relinquished property.
- Close on the replacement property within 180 days of completing the sale of the previous property or by the tax return due date for the year of the sale, whichever comes first.
A 1031 exchange allows investors to upgrade to different real estate classes or larger properties without incurring a significant tax bill. This strategy frees up more capital for investing in the new property.
For example, if an investor nets $400,000 from selling a property, they could reinvest that entire profit into a $1 million (or higher) property and take out a new loan to cover the remaining cost.
“The 1031 exchange helps the investors keep the money working for them, rather than paying out about a third of that equity in taxes,” said Dwight Kay, founder and CEO of Kay Properties and Investments and the kpi1031.com marketplace.
Beyond deferring taxes, a 1031 exchange helps investors preserve capital for reinvestment, accelerate wealth accumulation, facilitate generational wealth transfer and estate planning, and diversify their real estate holdings.
Tax-loss harvest
Tax-loss harvesting involves selling a nonprofitable rental property at a loss to offset the capital gains taxes on profitable properties. This strategy helps manage and minimize capital gains taxes and taxable income.
| Transaction | Amount |
|---|---|
| Profit on Property A | +$40,000 |
| Loss on Property B | –$45,000 |
| Remaining loss | –$5,000 |
Here's an example: Suppose you earned $40,000 from selling a rental property (Property A). At the same time, another property fails to turn a profit, so you sell it for a $45,000 loss (Property B).
Your $45,000 loss would offset your $40,000 profit from Property A, so you’d owe no taxes on the capital gain (which would have cost $8,000 on a $40,000 profit at a 20% tax rate). And, you'd have a $5,000 loss to show on your taxes.
With the remaining $5,000 loss, you can offset $3,000 of your ordinary income, and then carry the leftover $2,000 forward to offset income in a later tax year.
“This is why (real estate) is a popular investment,” said Flint Jamison, founder of Vestus Capital. “It’s not always about what you make; it’s what you keep."
However, avoid selling underperforming assets solely for the tax benefits. Carefully analyze the long-term potential of your properties to determine which ones to keep and which to cut loose.
📅 Timing and rules for tax loss harvesting
Remember, you must sell both gain and loss assets within the same tax year.
Additionally, short-term losses offset short-term gains, and long-term losses offset long-term gains; they can't be mixed and matched. However, if your losses of one type exceed your gains of the same type, you can apply the excess to the other type.
For example, if you sell a long-term investment at a $15,000 loss but have only $5,000 in long-term gains for the year, you can apply the remaining $10,000 to offset any short-term gains.[2]
If you decide to pursue tax-loss harvesting, consult a tax professional to ensure you report the sales correctly and maximize the benefits.
Turn your rental into a primary residence
Sales of primary residences are eligible for a capital gains exclusion — up to $250,000 for a single individual or $500,000 for a married couple filing jointly.
To qualify, you must have owned the property for at least five years immediately before the sale and lived in the home for at least two years (the years as a resident don't need to be consecutive.)[3]
The amount you can exclude from capital gains taxes depends on how long the property was a rental versus how long it was your primary residence. Here's an example:
- You owned a home for 10 years and lived in it as your primary residence for four years. You can exclude up to $250,000 of your capital gains if you’re single or $500,000 if you’re married and filing jointly, regardless of the time it was used as a rental.
- If you sell the house at a $400,000 profit, you can exclude up to $250,000 (if single), leaving $150,000 subject to taxes.
- If you're married and filing jointly, you can exclude up to $500,000, so you would owe no capital gains tax on the $400,000 profit.
Note that depreciation recapture rules apply, and you’ll need to pay taxes on any depreciation deductions you took while the property was a rental.
In addition, be sure to document your intent to rent the property. The IRS may require you to provide rental agreements, financial records of rental income, and even advertisements listing the property.
Be strategic about when you sell
Selling at the right time is essential to maximize your tax benefits. The length of time you hold your property can significantly affect your capital gains tax rate, depending on your income and filing status.
- If you hold your property for less than a year, you’ll be subject to short-term rates, which could be as high as 37%.
- By contrast, holding on to a property for more than a year bumps you to a long-term rate of 0%, 15%, or 20% based on your specific circumstances.
The difference can be substantial: for a $200,000 capital gain, your tax liability could be up to $40,000 at a long-term rate, compared to up to $74,000 at a short-term rate.
Being strategic about when you sell your rental property can significantly impact your finances. Understanding the implications of short-term versus long-term capital gains rates allows you to make informed decisions that optimize your tax benefits.
Connect with top realtors to boost profits
Maximize your profits by selling at the optimal time. Use Clever Real Estate to connect with top-rated realtors in your area who can help you determine the best time to sell your rental property and navigate the complexities of the market.
Taxes on a rental property sale: The bottom line
Rental properties are often profitable investments with exceptional tax benefits. But to fully capitalize on these benefits, you need to plan your property sale with the help of professionals.
Real estate agents can help you sell your rental at the best time and for the highest amount based on market conditions; tax advisors will ensure you comply with all relevant laws, minimizing your tax liabilities and maximizing your profits.
By being strategic about the timing of your sale and leveraging professional advice, you can maximize your investment returns.
