Capital gains taxes are taxes you pay on profit from selling your real estate investment property. The amount of capital gains taxes you pay varies depending on the profit made and your specific situation.
For successful investors, selling a property can result in significant capital gains tax if you don't take action to prevent. I used the strategies in this guide to defer paying any capital gains tax on a fourplex I sold and turned it into a large investment package with 18 apartments.
What Are Capital Gains Taxes
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 and the cost of any improvements from the final selling price. The resulting number is your capital gain.
Capital gains taxes come into play when you sell your property at a profit — or gain. Unlike sales tax or income tax, you only owe the IRS these taxes once you've wiped your hands of the property and handed over the title to the new owner.
Short-term capital gains is the profit you make if you've owned the investment property for less than a year. Long-term gains on investments you held for over a year. 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 Are Capital Gains Tax on Investment Property?
To answer this question, we must take a deep dive into some tax terms. For starters, your cost basis is the price you paid when you initially purchased the property, including closing costs.
Add to this number the cost of any improvements you've made over the years — this can include things like a kitchen renovation, a new roof, or a replaced sewer line. This doesn'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.
Your capital gains are calculated by subtracting this total cost basis from the price you sell the property for, minus all closing costs like realtor or title fees.
. 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 and how much your income is, you will either pay short term or long term capital gains at the following rates.
How Much Are Capital Gains Tax on Investment Property?
|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|
Long Term Capital Gains
|Tax Rate||Single||Married, filing jointly||Married, filing separately,||Head of household|
Depreciation Recapture - Another Tax When You Sell investment Property
While most investors are often the most concerned about capital gains, depreciation recapture is actually the first 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.
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.
How To Avoid A Tax Hit When You Sell Investment Property
If you're going to sell an investment property, there's four tools a savvy investor can use to avoid a big tax hit.
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
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.
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 sales 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.
The seller of the property technically sells the property to the intermediary for an instalment 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. Its a 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.
Turning a rental into your primary residence
The last way to avoid a tax hit doesn't work in every situation, but if your rental property was a single family home, and you're willing to move in for two years, you can drastically reduce or remove your capital gains by selling the property as your primary residence. 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.
Top FAQs About Capital Gains Taxes for Investment Properties
Can I move into my rental property to avoid capital gains tax?
The IRS says that if you live in a home as your primary residence for at least two out of the last five years, you qualify for the tax-free gain exclusion. But, here's where things get tricky. You'll only save a certain percentage of depreciation recapture and capital gains taxes and this percentage depends on what percent of the time the property served as your primary residence (qualified use) and which percentage it was used exclusively as a rental property (non-qualified use).
For example, if you've lived in the home as your primary residence 5 out of the 10 years you've owned it, you'll fulfill the tax-free gain exclusion. But, since you only lived in it half of the time, 50% of the gain is subject to depreciation recapture and capital gains taxes. Rather than being taxed on the full profit amount, you'll only be taxed on half of it. Always refer to your tax professional for advice on your specific situation.
If you sell your second home for a major profit, it's likely you'll pay at least some capital gains taxes. But, there are some ways to reduce this amount, if not avoid it altogether. If you have lived in the home as your primary residence for at least two of the past five years, you fulfill the tax-free gain exclusion. This means the percentage of time you have lived in the property over the time you have owned it is excluded from your capital gains.
For example, if you lived in the home exclusively for two out of the last 10 years, 80% of your gain would still be subject to capital gains tax. The remaining amount — if under the $250,000 allowable exclusion for single taxpayers — would be free of this tax.
There are other ways to save — one tactic being using deductions to your advantage. Just as you primary residence, if you don't rent out your second home and have a mortgage, you can claim the mortgage interest deduction. You can also deduct the amount you pay in property taxes.