If you sell your property, you may end up owing capital gains tax. No one wants to be hit with an unexpected tax bill. If you’re investing in rental property, make sure you know what to expect and how to avoid capital gains on an investment property.
Always consult with an experienced real estate tax advisor for advice that is relevant to your unique situation. Certain strategies may help you avoid paying more in capital gains than necessary:
- Keep records of improvements. You may be able to add the cost of improvements to your cost basis, reducing your capital gains.
- Use tax harvesting. Your capital losses can offset your capital gains. If you have a poorly performing investment you want to get rid of, selling it at a loss can reduce your tax burden.
- Use seller financing. If you finance the sale, the buyer pays you in installments. This allows you to defer some of your capital gains. However, consider the risks before proceeding with this strategy.
The IRS Section 121 exclusion and rental property
Let’s say you buy a property for $500,000 and sell it five years later for $600,000. Ignoring other issues related to the cost basis (which we’ll dive into shortly), that’s a tidy profit of $100,000 – but that profit may be subject to capital gains tax.
The IRS says you can exclude a certain amount of capital gains when you sell your home – this is the Section 121 exclusion. If you’re filing individually, you can exclude up to $250,000. If you’re filing jointly with a spouse, you can exclude up to $500,000.
If the property in the above example is your home, you may be in the clear with that $100,000 profit. But there’s a catch: the Section 121 exclusion only applies if you have owned and used the property as your main home for at least two years in the five years before the sale. If you’ve been renting the property, it’s considered commercial property, which means you can’t claim the capital gains tax exclusion due to the Section 121 five-year rule.
IRS capital gains on commercial property
Real estate typically increases in value, meaning it will often be worth more when you sell it than when you bought it. For rental property not subject to the Section 121 exclusion, this means you will likely owe capital gain tax.
The IRS says the capital gains rate is typically 0%, 15%, or 20% for assets you’ve held for at least one year:
- 0% if your taxable income is less than or equal to $41,675 and you’re filing individually or $83,350 and you’re married filing jointly.
- 15% if your taxable income is between $41,675 and $459,750 and you’re filing individually or $83,350 and $517,200 and you’re married filing jointly.
- 20% if your taxable income exceeds the limits for the 15% rate.
If you’ve held your property for less than one year, it’s considered a short-term capital gain and is subject to taxation as ordinary income. Additionally, the 3.8% Net Investment Income Tax may apply if you have net investment income. This applies if your modified adjusted gross income is more than $200,000 and your filing status is single or if your modified adjusted gross income is more than $250,000 and your filing status is married filing jointly.
Calculating your capital gains or losses
Calculating your capital gains or losses isn’t as easy as determining the difference between what you paid and what you received in the sale. You need to determine the cost basis, which includes factors beyond the purchase price. Most notably, you’ll need to subtract depreciation and add the cost of allowable improvements. Once you have the cost basis, you can compare it to the sale price to determine your capital gain or loss.
How to defer capital tax on real estate using a 1031 exchange
If you’re selling one rental property in order to buy another, you may be able to avoid capital gains taxes through IRS Section 1031. This tax rule allows for like-kind exchanges, which occur when you exchange an investment property for another of the same type – or of “like-kind.” If your transaction qualifies as a like-kind exchange, you do not have to pay a capital gain or loss.
In order to qualify for a 1030 exchange, the following conditions must be met:
- The property being sold (the "relinquished property") must be exchanged for another property (the "replacement property") that will be used for the same purpose.
- The properties must be of "like-kind", meaning the same nature or character.One apartment building would be considered like-kind to another apartment building – even if the quality is different – provided you meet the other criteria for the exchange.
- The replacement property must be identified within 45 days of the sale of the relinquished property, and the replacement property must be acquired within 180 days of the sale of the relinquished property.
- The taxpayer must not receive any cash or other "boot" as part of the exchange.
- Work with a qualified intermediary to facilitate the exchange.
- Both the relinquished and replacement property must be held for use in a trade or business or for investment.
- The taxpayer must be the same on both the relinquished and replacement property.
State rules on capital gains
The Center on Budget and Policy Priorities says most states tax income from investments and income from work at the same rate, but nine states tax all long-term capital gains at a lower rate. These states are Arizona, Arkansas, Hawaii, Montana, New Mexico, North Dakota, South Caroline, Vermont, and Wisconsin.
A few states, including Colorado, Idaho, Louisiana, and Oklahoma, have tax breaks that apply to capital gains on investments for in-state businesses. New Hampshire does not have an income tax but does have a capital gains tax. Washington recently passed a similar tax law that is supposed to take effect in February 2023 but is being challenged.
All of this means that how much you owe in state capital gains – or whether you owe anything – depends on where you live. For example, the Californian tax on the sale of rental property mirrors the federal IRS rules. Property owners can also use the 1031 exchange rules in California, but they need to watch out for the California claw-back rule, which means you may eventually owe California capital gains tax if you sell a California property and use the 1031 exchange rule to buy a property outside of California.