For most investors, selling a rental property is an exciting time, as we're probably going to be using the proceeds from the sale to buy an even bigger and more profitable investment.
Large investments can get expensive quickly, and it's important to maximize the proceeds from the sale of the previous property to make as much capital as possible available for you next down payment. Typically when an asset like a stock is sold, its subject to either short or long term capital gains. However, real estate has several exclusions that make it possible to either defer or completely avoid paying taxes on the appreciation of your property.
How Much Tax Do You Pay When You Sell A Rental Property
Capital gains tax will typically be the most important tax consideration when selling a rental property. If you don't take any action to defer capital gains taxes, the profit from the sale of your property is taxed at the following rates. Anything you own for a year or less is taxed as short term capital gains, and anything more than a year is long term.
2020 Short Term Capital Gains (by income)
|Tax rate||Single||Married, filing jointly||Married, filing separately||Head of household|
|10%||$0 to $9,875||$0 to $19,750||$0 to $9,875||$0 to $14,100|
|12%||$9,876 to $40,125||$19,751 to $80,250||$9,876 to $40,125||$14,101 to $53,700|
|22%||$40,126 to $85,525||$80,251 to $171,050||$40,126 to $85,525||$53,701 to $85,500|
|24%||$85,526 to $163,300||$171,051 to $326,600||$85,526 to $163,300||$85,501 to $163,300|
|32%||$163,301 to $207,350||$326,601 to $414,700||$163,301 to $207,350||$163,301 to $207,350|
|35%||$207,351 to $518,400||$414,701 to $622,050||$207,351 to $311,025||$207,351 to $518,400|
|37%||$518,401 or more||$622,051 or more||$311,026 or more||$518,401 or more|
2020 Long Term Capital Gains (by income)
|Tax Rate||Single||Married, filing jointly||Married, filing separately,||Head of household|
How much tax you pay on the sale of a rental home will depend on three factors: your current income tax bracket, the number of years you've owned the rental property, and your approach to avoiding tax.
Strategies To Avoid Or Defer Capital Gains Tax When You Sell
If you're looking at the chart above, and you're not excited about the prospect of a large tax bill, there are 4 main ways you can reduce, defer, or avoid paying taxing on your capital gains.
A 1031 exchange, also known as a like-kind exchange, is an IRS tax regulation that allows property owners to swap one investment property for another on a tax-deferred basis, and defer paying any capital gains when the property is sold.
In most cases, selling one investment property to buy another would be a taxable sales transaction. However, if a real estate swap meets the condition of a 1031 exchange, any unrealized capital gains on the property sale can be deferred until you sell the asset for cash.
Savvy property investors can leverage the tax deferment benefits of a 1031 exchange to rapidly expand their investment portfolio by using the taxes they deferred as the down payment on another property. A 1031 exchange was one of the main drivers of the growth of my own portfolio.
I did a 1031 exchange on a fourplex that I house hacked about a year after purchasing it, after the significant renovations I did raised its value enough to change my long term plans from holding the property to selling it and using the proceeds to buy something bigger.
I ended up using the profit from that sale as a down payment of a portfolio that consisted of 18 total apartment buildings.
1031 Exchange Rules
IRS Section 1031 encompasses a complex set of real estate procedures and regulations. To help you understand what you can and can't do during a 1031 exchange, we've listed six key rules to remember:
- A 1031 exchange can only be used for property swaps involving business or investment assets.
- There's no limit on the number of times you can sell and buy business or investment properties through a 1031 exchange.
- In a 1031 exchange, when you close on the initial property sale, you only have 45 days to identify the “swap property” you intend to purchase with the sale proceeds.
- After identifying the “swap property,” you only have 180 days to settle the final purchase transaction.
- Any cash left over after acquiring your secondary property is taxed as partial capital gains proceeds.
- If you sell a depreciable property through a 1031 exchange, special depreciation recapture rules can apply. For more information, check out our in-depth guide to 1031 exchange rules in real estate.
Turning Your Rental Property Into A Primary Residence
Moving into your rental property and converting it to a primary residence is a viable option for reducing your tax liability. This is because the sale of a primary residence can qualify for the capital gains tax exclusion.
Remember, because of congressional and IRS restrictions, the capital gains tax exclusion cannot be used for depreciation related capital gains.
How do you convert a rental property to a primary residence?
If you want to qualify a former rental home for the capital gains tax exclusion, the property will need to meet the following eligibility requirements:
- The property in question must be your primary residence.
- The property in question must not have been purchased through a 1031 exchange in the last five years.
- You must have owned the property in question for over two years.
- Any previous capital gains tax exclusion claims must have occurred over two years prior to the sale of the property in question.
If you've converted your rental home to a primary residence and meet the previously listed requirements, you can exclude up to $250,000 of capital gains as a single filer, or $500,000 of capital gains as joint filers.
Monetized Installment Sale
A monetized installment sale is a tax treatment category that allows property sellers to use a deferred financing installment contract to postpone capital gains recognition on their home sale.
In a traditional property transaction, when you close on the sale of an appreciated real estate asset, you receive, and subsequently pay tax, on a lump sum of cash.
In a monetized installment sale, the property owner refrains from directly selling to their chosen buyer. Instead, the home is temporarily sold to an intermediary dealer. This property sale is contingent on the dealer reselling the home to your final buyer.
In most cases, you, the property owner, will have already locked in a final buyer prior to selling to the intermediary dealer. After the dealer resells your rental property, you'll receive a principal payment installment contract.
In the meantime, the cash proceeds from the dealer's sale are held in an escrow account. When the escrow account deposit is confirmed, you will receive a limited-recourse, interest-only, no-money-down loan from a third-party lender — this loan is usually worth around 95% of the final buyer's purchase price.
By the time the installment contract is due, the principal payments from the dealer will either equal or exceed the total interest paid on the seller's loan. At this point, the seller's capital gains will be recognized and taxed by the IRS.
Tax Loss Harvesting
Tax loss harvesting, also known as tax-loss selling, is the practice of selling one property at a loss to offset the gains from another property. If you have property thats underperformed, or in an area that's losing value, it might be a good idea to sell it at the same time you sell a profitable asset to mitigate your taxes.
Realtor Commission - Another Way To Save When You Sell
If you're selling a rental property, the strategies in this post are a great way to lower the tax you have to pay for capital gains. Another great way to net more when you sell an investment property is to work with an agent that will reduce their commission rate.
At Clever, we've negotiated rates with over 8,000 top agents around the country, and they will list your home for a flat fee of $3,000 if the home is less than $350,000, or just 1% if the home is more expensive. That fee is only paid if the home sells, and we've helped thousands of sellers sell their home and save to date.