Setting up investment properties are exciting. The sky’s the limit with the possibilities that are going to happen for you moneywise, and you can almost taste the success. After you get a few under your belt, you may decide to sell off one or two of the lower-producing rental properties and have that cash to put down on some other homes. Only to find when you go to sell, there are taxes in place to take a big chunk of the money you’ve earned. So, what do you do? Is there for you to avoid taxes when you sell a rental property?
How much tax will I pay when I sell my rental property?
The tax we are referring to is called Capital Gains tax. It only occurs when you sell an asset for more than you acquired it for, making the income you get from the sale the capital gains. You can avoid the tax if you have owned and lived in the house for two years within a five year period of the sale and you haven’t excluded another home’s sale from taxes within that two year period. If this doesn’t apply to you, then you will be responsible for paying the tax. It depends on your level of income, but as of 2018, the Capital Gains tax rate tops out at a whopping 37%. So, if you got $100,000 profit from the sale of the house, that means $37,000 would be taxed if you were in the top tax bracket. It is different depending on how long you have owned the home, however. If you have lived in it for less than a year, the profit is taxed as ordinary income. It’s only when you own the property for over a year that the Capital Gains tax applies.
Can you avoid Capital Gains Tax?
The short answer is yes, but it takes a lot of work, some conditions may be uncomfortable to adhere to, although I’m not sure if they’re as painful as shelling out 37% of the profit from your rental. Some of these ways to avoid the tax are by using the 1031 exchange, tax loss harvesting, and recapturing your depreciation.
A 1031 exchange is basically a way of talking one investment property, selling it, and putting all of that money into another investment property or properties. You do this to avoid substantial tax implications from the Capital Gains Tax. Essentially, you are changing the form of your investment without cashing out or recognizing capital gain. Without any real monetary gain on the property, you won’t have to pay the taxes. There are several ways to do this.
Let’s say you have a bunch of rental properties that you want to pass down to your children, and they want to sell them. If you used the 1031 exchange to acquire those properties, your children would only have to pay taxes on the amount gained, not the whole amount the properties are worth.
To Build Your Investment Portfolio
If you don’t want to use the 1031 exchange for inheritance purposes, you can use it to increase your portfolio. Here’s the scenario: You want to sell a low performing rental property. If you go through a 1031 exchange, you could sell your property for 300k, put $100,000 down on three different properties (like a quadplex, an apartment complex, and a commercial building) and only pay taxes on the money gained.
After a year and a day, you can then sell each property and purchase three more (without penalty) per property sold and see an even more substantial return on your investment. If you put money down on more than three properties for every one property sold, however, you will be subject to a fee. The catch is this: from the sale of the home; you only have 45 days to close on your other properties, and all the money from the sale of the initial property must sit in an escrow account during that period. While you could ask a trusted friend to put the money in their account for you, there are professionals out there who charge a small fee to hold your money until you close on any additional properties.
Tax Loss Harvesting
If the property you want to sell has depreciated to the point of it being a loss for you to sell it, you can claim a tax loss and not have to pay Capital Gains tax on it. You get credits for the loss that go toward your capital gains on the property. You are not able to purchase a nearly identical asset within 30 days before or after the sale, or you will be subject to the Wash Sale Rule. If you are subject to the Wash Sale Rule, you will be disqualified from harvesting a loss and must pay up. Make sure you speak with your accountant before making any decisions about taxes, though.
Throughout ownership of the property, you can deduct depreciation on your property from your taxes annually. Depreciation is claiming the value of your property is declining because you are renting it out. You can claim this until you have deducted the entire amount of your loan or until you sell.
When you choose to sell your property, however, the Federal Government charges a 25% tax on depreciation recapture. This means you will have to pay a portion of the money that you got to keep from the depreciation back to the government upon sale.
The only real way to be exempt from paying Capital Gains taxes on the sale of a property is to do the 1031 exchange. This is great news for those looking to build their investment portfolio, but bad news for those wanting to liquidate your assets. To learn more about 1031 exchanges, check out this article here.
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