Selling your investment property can be a real treat, especially for those looking to get some equity back on their home. But watch out for capital gains tax! Here’s what you need to understand about capital gains tax on real estate investment property.
What are capital gains taxes?
Like most things in the United States, selling your home can be taxable. Although you may have enjoyed your mortgage interest being tax deductible all these years, that will change when you decide to sell. Capital gains tax is a tax on the difference between what you paid for something and what you sell it for. This mainly pertains to big ticket items like cars, boats, real estate, and stocks.
The main difference between capital gains and other taxes like sales tax or income tax is that you won’t pay capital gains for the period that you own the property. The IRS will only ask for their money once you sell the property and make a profit.
There are two main types of capital gains taxes: short-term and long-term. Short-term capital gains apply if you owned the home for less than a year. Long-term capital gains tax rates apply if you owned the home for more than a year. The amount of tax you’re charged will depend on the type of capital gain but can range from 0 to 15 percent (and higher).
How much capital gains tax will I have to pay?
The best advice when trying to determine tax amounts is always to consult an accountant or CPA. They can give you a much more accurate picture based on your overall financial situation, including your current tax bracket and existing taxable income, all information found on your tax return.
If you just want to find out a ballpark amount, there are some simple ways to calculate your capital gains. In order to calculate the amount you will be taxed on you will need to know:
- Amount the property was purchased for
- How much money was spent to improve the property
- Sales price of the property
For example, if you paid $100,000, spent $25,000 on improvements, and sold the home for $200,000, your capital gains would be $75,000. How much tax you will pay on this gain is based on your household income. Here is a chart from Bankrate.com to help you estimate that amount:
2018 Long-Term Capital Gains Tax Brackets
Tax Rate Single Joint Head of Household
0% $0 to $38,600 $0-$77,200 $0-$51,700
15% $38,601-$425,800 $77,201-$479,000 $51,701-$452,400
20% $425,801 and up $479,001 and up $452,401 and up
So, if we take the first example, where your gain was $75,000, and you’re single and make $80,000 per year, your tax rate would be 15%. That’s a total of $11,250 in capital gains taxes that you would have to pay.
Avoiding Capital Gains Tax in Real Estate Investment Property
There are some pretty simple things that can offset the amount of capital gains tax you will have to pay. One is just being married!
The IRS typically allows you to exclude up to:
$250,000 of capital gains if you’re single.
$500,000 of capital gains if you’re married and filing jointly
So just being married can double the amount that you are able to escape being taxes on. However, the big wild card here is that this only applies to your primary residence. Since we are discussing capital gains on investment property, it is likely we aren’t discussing your main home.
If we are talking about an investment property, either a vacation home or rental property, there are still some ways to minimize how much tax you have to pay. Lots of these strategies are used by real estate investors who don’t want to pay taxes.
One simple thing that investors do is to use their financial losses to offset ordinary income. Again, this is something your accountant can help you to better understand, just know that it is an option.
Another option is to buy and sell properties with a family member who is in a lower tax bracket. They assume your cost basis for the gain—but are taxed at their rate, resulting in less overall tax rates.
By far, the more popular thing that investors use to minimize their tax is something called a 1031 exchange. This is a tax code that allows you to reinvest the profit from the sale of one property by purchasing another. Doing this allows you to avoid capital gains and depreciation recapture taxes because you’re basically just moving money from one investment to another.
There are a few important rules to follow if you are thinking about doing this. A 1031 exchange has time restrictions. You must reinvest your money in 180 days. You also have to make sure that you are doing a like-kind exchange, meaning that you aren’t selling a multi-family home and buying a boat.
Doing the Math on Capital Gains
Investing in property can definitely be lucrative, but it can also be a financial headache. Make sure to get good advice from someone who knows what they are talking about, like your accountant or real estate agent. Calculate the costs associated with owning an investment property and make sure that it’s the right move for you.
These costs include the upfront purchase price, any improvement costs, and upkeep. But don’t forget about the long-term costs like capital gains, which can really take a bite out of your profit if you’re not careful.