Nobody wants to pay capital gains tax on real estate investment properties—it cuts into your profits. The trick is knowing how to reduce, defer, or avoid paying capital gains tax all together when you sell your investment property.
As a real estate investor, licensed real estate agent, and co-founder of Clever Real Estate, this is something I've experience firsthand. Over the past several years, I've grown my portfolio to 22 units and completed a successful 1031 exchange to defer my capital gains taxes.
I used the strategies in this guide to defer paying any capital gains tax on a fourplex multifamily home I sold and turned it into a large investment package with 18 apartments. Here's what I learned about capital gains tax on real estate in the process.
Sell your investment property with a top Clever agent, save thousands on commission.
Clever vets agents based on performance from Berkshire Hathaway, Keller Williams, and other top brokerages and negotiates lower insider rates on your behalf. When you work with Clever, you can sell for just 1.5%—roughly half the traditional fee.
What are capital gains taxes?
Capital gains taxes are the taxes you'll pay on your capital gain. Unlike sales tax or income tax, you only owe the IRS these taxes once you’ve handed over the title to the new owner. To know how much capital gains taxes you'll owe, you first need to calculate your capital gains.
Capital gains are your net profit when selling something you own. With real estate, it is calculated by subtracting the amount you paid for the property (including closing costs) and the cost of any home improvements from the final selling price.
Home improvements can include things like a kitchen renovation, a new roof, or a replaced sewer line. They can't include the cost of paint for the living room, a microwave, or a mower—only items that increase the property value or extend its useful life.
Read: 16 Home Improvements to Boost Value in 2024
“In addition to major home improvements, property owners can increase their cost basis by including other expenses such as legal fees, recording fees, surveys, transfer taxes, title insurance and similar fees,” explains Herb Montgomery, a certified financial planner and the owner of Montgomery Financial Group in Orleans, MA.
The resulting number from that equation is your capital gain. This applies to selling investment properties as well as selling your primary residence. The only difference with selling your primary residence (or a rental property that was once your primary residence) is that you may qualify for the capital gains tax exclusion. Learn more about the capital gains tax exclusion below to see if you qualify.
Capital gains = what you sold the property for (cost basis) - what you paid for the property (selling price) - the cost of major home improvements
Short term vs. long-term capital gains taxes
Short-term capital gains is the profit you make if you’ve owned the investment property for less than a year. Long-term capital gains apply to investments you've held for over a year. Short-term capital gains rates are the same as your income tax rates. Long-term capital gains rates are either 0%, 15%, or 20%, depending on your income bracket.
Since there are quite a few caveats to capital gains taxes, always be sure to consult your CPA to discuss your specific situation before taking action.
How much is capital gains tax on an investment property?
The amount of capital gains tax you'll pay on an investment property sale depends on how much you bought it for, how much you sold it for, how many home improvements you did, how long you've held the property, what your income is, your filing status, and what you're doing with the capital gains from the sale of the investment property.
For example, If you purchased an investment property for $100,000 plus $5,000 in closing costs, and then added $20,000 in improvements over the years, your cost basis would be $125,000. If you sell the same property for $225,000, your capital gains would be $100,000.
Based on how long you’ve held the property for, you will either pay short-term or long-term capital gains.
Was your investment property ever your primary residence?
If you've lived in your investment property for at least two of the last five years from the date you sold it, you can qualify for the capital gains tax exclusion. This will let you exclude $250,000 in capital gains if you file your taxes as an individual, or $500,000 if you’re married filing jointly. Learn more about how to save on capital gains taxes when your rental property is used as a primary residence.
Short-term capital gains tax rates for 2024
If you've held an asset for less than a year before you sell it, you'll pay short-term capital gains tax. The rate you'll pay depends on your income bracket and your tax filing status. Your short-term capital gains tax rate will be the same as your federal income tax rate. For state taxes, check your state's tax website or ask a certified tax professional.
| Tax rate | Single | Married, filing jointly | Married, filing separately | Head of household |
| 10% | $0 to $11,600 | $0 to $23,200 | $0 to $11,600 | $0 to $16,550 |
| 12% | $11,601 to $47,150 | $23,201 to $94,300 | $11,601 to $47,150 | $16,551 to $63,100 |
| 22% | $47,151 to $100,525 | $94,301 to $201,050 | $47,151 to $100,525 | $63,101 to $100,500 |
| 24% | $100,526 to $191,950 | $201,051 to $383,900 | $100,526 to $191,950 | $100,501 to $191,950 |
| 32% | $191,951 to $243,725 | $383,901 to $487,450 | $191,951 to $243,725 | $191,951 to $243,700 |
| 35% | $243,726 to $609,350 | $487,451 to $731,200 | $243,726 to $365,600 | $243,701 to $609,350 |
| 37% | $609,351 and up | $731,201 and up | $365,601 and up | $609,351 and up |
Long-term capital gains tax rates for 2024
If you've held an asset for over a year before you sell it, you'll pay long-term capital gains tax. The rate you'll pay depends on your income bracket and your tax filing status. For state taxes, check your state's tax website or ask a certified tax professional.
| Tax Rate | Single | Married, filing jointly | Married, filing separately | Head of household |
| 0% | $0-$47,025 | $0-$94,050 | $0-$47,025 | $0-$63,000 |
| 15% | $47,025-$518,900 | $94,050-$583,750 | $47,025-$291,850 | $63,000-$551,350 |
| 20% | $518,900+ | $583,750+ | $291,850+ | $551,350+ |
Depreciation recapture: the tax people forget about
While most investors are often the most concerned about capital gains taxes, depreciation recapture is another tax bill you have to pay when you sell an investment property.
Most investment property can be depreciated over a period of 27.5 years, or 3.636% per year. Investors are allowed to use this depreciation to lower their taxable income each year. Unfortunately when you sell an investment property, the IRS gets those savings back in the form of depreciation recapture.
“People who rent out their properties often depreciate the value each year, so they can reduce the amount of taxes they pay annually,” explains Herb Montgomery. “The total amount of the depreciation must be added back into the value of the home.”
If you make a profit on the property in an amount more than the depreciated value (regardless of whether you claimed it), you must pay depreciation recapture tax at a rate of 25% on that overage amount. Ouch. Any profit over this amount will be taxed at the lower capital gains tax rate you see above.
You can estimate your depreciation recapture taxes with this depreciation calculator. But you'll get the most accurate numbers by consulting your CPA.
How to minimize taxes when you sell an investment property
If you’re going to sell an investment property, there’s four ways a savvy investor can reduce the capital gains tax they're required to pay.
Use a 1031 exchange
Perhaps the most popular technique is the 1031 exchange. This tax code allows you to reinvest the profit from the sale of one investment property into the purchase of another without paying capital gains and depreciation recapture taxes on the sale of the first property. In simplest terms, you’re just moving your money from one investment to another.
There is some fine print though—you need to reinvest the money within 180 days and do a like-kind exchange, purchasing the same kind of investment as you owned previously. You also need to use a qualified intermediary, so you have to decide to do a 1031 exchange before you complete the sale of your first property.
Take advantage of tax-loss harvesting
Tax-loss harvesting is a great way to make the best of a bad situation. This works by offsetting the capital gains from one property against the losses of another. If you’re selling a property for a big gain, and you have another property that’s depreciated in value, tax loss harvest might be a good idea, as you can sell the poorly performing property to lower the net gain that is taxed.
Set up a monetized asset sale
If you still want to avoid a tax hit but don’t want to do a 1031 exchange or tax-loss harvesting, a monetized asset sale is a great alternative that lets you walk away with 95% of the sale price, without having to pay capital gains for 30 years.
This is a complicated arrangement that involves the buyer, the seller, an intermediary, the buyer’s lender, and the seller’s lender.
How it works: The seller of the property technically sells the property to the intermediary for an installment contract: a 0% down loan with payments over the next 30 years. The intermediary then resells the property to the buyer (already found by the seller) at the same price that they paid for the property. The seller then exchanges the installment contract for a cash payment for 95% of the property. The intermediary then sets aside the needed funds from the sale of the property in an escrow account to pay off the loan over the next 30 years.
This allows the seller to delay paying capital gains until the end of the 30-year note, and the seller can write off their interest payments during that time. It's complicated, but a monetized asset sale can be a great way to reduce your upfront cost if you don’t want to do a 1031 exchange.
Watch out for this: You'll also want to be sure you use a trusted professional for a transaction like this. The IRS has warned high-income filers of scams involving monetized installment sales.
Turn your rental into your primary residence
The last way to avoid a tax hit doesn’t work in every situation, but if you've lived in your rental property as your primary residence for two of the last five years from the date that you sell it, you can drastically reduce or remove your capital gains. This will let you exclude $250,000 in capital gains if you file your taxes as an individual, or $500,000 if you’re married filing jointly.
You may still have to pay taxes through depreciation recapture though. Always consult a certified tax professional before making any financial decisions with strong tax implications.
