Investing in real estate is one of the best means to make income and create real wealth. When an investor sells a long-term rental property at a profit, they’ll benefit from a nice payout of cash. Nevertheless, they will also be responsible to pay capital gains taxes on the money generated from that investment property.
So what happens if tax season rolls around and capital gains taxes take half of your investment return? This situation happens to real estate investors all the time. It’s like receiving a $10,000 bonus at work and only getting $7,800 after taxes.
The great news is, there are avenues for real estate investors to avoid capital gains tax on property.
The article will explore capital gains tax on real estate investments, how to calculate capital gains tax on the sale of the property, and how to avoid capital gains tax on an investment property.
Table of Contents
- 1 What are Capital Gains?
- 2 What Are Capital Gains Taxes on Real Estate Investments?
- 3 How is Capital Gains Calculated on Investment Property?
- 4 How To Avoid A Capital Gains Tax on Investment Property?
- 5 How is Capital Gains Calculated on Sale of Rental Property?
- 6 How to Avoid Capital Gains Tax on Rental Property?
What are Capital Gains?
Capital gains are the profits produced from selling an investment. If an asset is later sold at a higher price, that “increase” would be deemed as a capital gain. This could lead to profits resulting from selling stock market investments, real estate assets, a business, land, etc.
For instance: A stock you bought 10 years ago for $5,000 is now worth $55,000. When you sell the stock, that $50k is deemed as a capital gain and will be taxed accordingly.
Essentially, capital gains are any investment that generates a monetary return when it’s sold. However, investors may encounter capital losses with their investments.
What is a Capital Loss?
A capital loss is when an investment is sold for less than its original buying price. Capital losses are critical when it comes time to file taxes because they can be deducted from capital gains. Investors will employ capital loss strategies to offset their capital gains taxes.
What Are Capital Gains Taxes on Real Estate Investments?
Capital gains from real estate investments are taxed when the asset is sold. Irrespective of how much the property realizes or appreciated over time, investors won’t have to fret about capital gains until they sell.
These taxes can be levied on both a state and federal level. Bear in mind that taxes on capital gains only are applicable to investment properties–not primary residences–as long as the homeowner lives in the home for two years or more.
Real Estate Capital Gains Tax Rates 2020
Most state tax capital gains at the same rate as your federal income tax. Some states are super tax-friendly and have no income tax and no capital gains taxes. Other states have no income tax, but still, tax dividends and interest. Where your rental property is situated will play a key part in how much you’ll be taxed for capital gains at a state level.
How long you own a rental property and your taxable income will decide your capital gains tax rate. Short-term investments held for one year or less are taxed at your ordinary-income tax rate. Tax rates for short-term gains in 2020 are: 10%, 12%, 22%, 24%, 32%, 35% and 37%.
Investments held long-term, more than one year will be taxed at a lower rate. The following are tax rates for capital gains on long-term real estate investments sold in 2020:
|FILING STATUS||TAXABLE INCOME||TAX RATE|
|SINGLE||Less than $78,750||0%|
|SINGLE||$78,750 – $434,550||15%|
|MARRIED (FILING JOINTLY)|| $78,750 – $488,850
|MARRIED (FILING SEPARATELY)|| $78,750 – $244,425
|SINGLE/MARRIED|| $488,851 or more
How is Capital Gains Calculated on Investment Property?
When you sell an investment property, any profits are exposed to capital gains taxes. But it’s not as easy as deducting what you paid for the property from what you sold it for. Rather, you determine the capital gain (or loss) by deducting the “cost basis” of the property from the “net proceeds” you make from the sale. This implies your profit — and tax burden — might be smaller than it looks at first glance.
Cost Basis of Investment Property
The cost basis is the amount you paid for the property, combined with:
- Valid costs associated with the purchase (e.g., some closing costs, appraisal fees, and legal fees).
- The cost of any major upgrades you made to the property.
For instance, if you paid $200,000 for the property, had $5,000 in closing costs, and spent $20,000 on upgrades, your cost basis would be $225,000 ($200,000 plus $5,000 plus $20,000).
Upgrades must add value to the property, alter its use, or make it last longer. Things like a new roof, an addition (such as a family room), or a kitchen remodel count as upgrades. Routine maintenance and anything you do only to make the property look nicer (e.g., purely cosmetic changes like painting the bedrooms) are not included.
Net Proceeds from Investment Property
When you sell your property, you don’t really get the full sales price. That’s for the reason that there are costs related to the sale — such as the real estate agent’s commission, home staging, house cleaning, lawyer fees, and transfer taxes.
You get to deduct the costs from the sales price to ascertain your net sales proceeds. If you sold your investment property for $300,000, for example, and you paid $18,000 in commissions and $4,000 in other costs, your net sales proceeds would be $278,000 ($300,000 minus $18,000 minus $4,000).
To calculate the capital gain on the property, deduct the cost basis from the net proceeds. If it’s a negative value, you have a loss. But if it’s a positive value, you have a gain.
Using the above examples, if you have a cost basis of $225,000 and net proceeds of $278,000, your capital gain on the property is equal to $53,000. And this would be the amount that your capital gains tax is dependent on. If you fall under the 15% long-term capital gains rate, you would owe $7,950 ($53,000 multiplied by 15%).
How To Avoid A Capital Gains Tax on Investment Property?
If you’re going to sell an investment property, there are ways a savvy investor can use to avoid capital gains tax on property.
Tax-loss harvesting is when an investor sells underachieving investments at a loss, in order to reduce capital gains taxes. This approach performs best if you’re seeking to get rid of bad investments and convert them into tax deductions.
Suppose last year you sold an investment property and received a net profit of $100,000. In the same year, you sold some bad stocks at a $75,000 loss. Because you are permitted to deduct capital losses from capital gains, your tax liability would now be $25,000. This is a common tactic used by investors to avoid paying big capital gains taxes. After selling investments at a loss, some investors may decide to reinvest that money.
Section 1031 Exchange
The IRS has defined under section 1031 a “like-kind” exchange of investment properties. This approach doesn’t decrease capital gains taxes, just postpones some or all of these taxes to a later date. Using a 1031 Exchange, investors may sell a rental property and “swap” it for a similar or “like-kind” property.
This is a great approach for investors seeking to get rid of poorly functioning real estate markets and into strong, expanding markets.
Monetized Asset Sale
If you still want to avoid capital gains taxes, but don’t want to do a 1031 exchange or tax-loss harvesting, a monetized asset sale is a great option that allows you to walk away with 95% of the sales price, without having to pay capital gains for 30 years. This is a complex arrangement that includes 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 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 puts aside the required funds from the sale of the property in an escrow account to pay off the loan over the next 30 years.
This lets the seller defer 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 complex, but a Monetized asset sale can be a great means to lower your upfront cost if you don’t want to do a 1031 exchange.
Transform Rental Into Primary Residence
There are way more tax advantages when you sell a primary residence as compared to an investment property. That’s why some investors will opt to convert a rental property into their primary residence. While this may not be an alternative for everyone, it can offer huge tax advantages.
To meet the criteria for primary residence tax exclusions, investors must own the property for at least five years and have lived in it for at least two of those years. When selling a primary residence, single investors may exclude as much as $250,000 of profits. And those that are married filing jointly can exclude up to $500,000 of profits. Converting a rental property into your primary residence can entitle you to big tax savings and assist avoid capital gains taxes.
Sell When Your Income is Low
Another great scheme to decrease the blow of capital gains on your investment property is to time when you sell. If you realize you’re moving into some difficult years or your spouse is preparing on leaving their job, that would be a great time to think about selling. Your income will be less, which may place you in a lower tax bracket and decrease your capital gains tax liability.
Donate to Charity / Gift It
Donating property to charity not only helps you avoid capital gains taxes, but also provides you with a tax deduction. The IRS permits investors to subtract the assets’ fair market value and the charity doesn’t have to incur capital gains taxes either (because they are tax-exempt).
Investors can also decide to gift property with increasing value to family members. This works well if the family member getting the gift is in a lower tax bracket because if they choose to sell, they’ll be taxed at a lower rate. Parents seeking to cut capital gains taxes might contemplate giving away some real estate assets to their kids now rather than later. Bear in mind that this strategy doesn’t work for dependents under the age of 24, (as they have no taxable income).
Wait ‘Till You’re Dead
This may sound bizarre, but maintaining your assets until you’re gone is a pretty normal estate planning tactic to avoid paying taxes on capital gains. Assuming the asset has gained over time, the beneficiaries can benefit from a “step-up” in cost basis. This “step-up” is to help compensate capital gains taxes on inherited assets.
How is Capital Gains Calculated on Sale of Rental Property?
To make you understand how to calculate capital gains for the sale of a rental property. We’ll use a fictional example so you can get to see how the numbers work out.
Let’s use a sale of $400,000 on a rental property that was bought for $340,000 four years ago. There are a few measures to calculate your rental property gains. Let’s work through them.
Step-1: Calculate the buying price or basis of your rental property.
The original basis is your buying price or $340,000 in this situation. In the scenario that you have carried over basis through multiple contiguous 1031 exchanges, your starting basis may be lower. Refer to a tax professional for deciding your starting basis.
Step-2: Add any expenditures you’ve incurred in order to enhance the quality of the property or other items that increase the basis.
Improvements or capital improvements raise the tax basis of the property and are added to the purchase price. There have been $25,000 in renovations made, and they must be “a material part of” the property. These are physical improvements, and they must add “real” value. This implies that an appraiser would add value to the property based on the renovations. Other items that increase basis involve assessments for local improvements, impact fees, legal fees, and zoning costs.
In this situation our adjusted basis would look like this:
$340,000 + $25,000 = $365,000
Step-3: Deduct any depreciation you’ve taken on the property and any other items that decrease basis.
Items such as depreciation, canceled debt, insurance proceeds for casualty or theft, proceeds from easements, and rebates lower the property’s tax basis and are deducted from the cost basis. For our example, the property had $25,000 in insurance reimbursements and the depreciation is taken was $10,000 per year for four years. The adjusted basis now appears to be:
$365,000 – $25,000 – $40,000 = $300,000.
Step-4: Deduct the adjusted basis from the sales price to ascertain what gains will be taxed under the current capital gains tax rate.
Now we can finally determine our gains. Your total gain is simply your sale price minus your adjusted tax basis.
Capital gain in this scenario: $400,000 – $300,000 = $100,000.
Step-5: Depreciation is taxed at 25%, and capital gains are taxed based on your tax bracket.
Long-term gains normally end up being taxed at either 15% or 20%, depending on your income for the year. Depreciation recapture, though, is taxed at a flat rate of 25% on any part of the gain that is attributable to depreciation. In this situation, that would be $40,000 out of the $100,000 total gain.
With $40,000 in depreciation, our taxes will be $40,000 x 25% = $10,000 of depreciation recapture tax.
The remaining portion of our gain is taxed at your long-term capital gains tax rate, presuming we’ve kept the property for more than a year. If we are in a 20% long-term capital gains tax bracket, our total taxes on this portion of the gain are: $60,000 x 20% tax rate = $12,000.
At this point, our capital gains tax responsibility would be $22,000 ($10,000 depreciation recapture + $12,000 on long-term gain).
Step-6: Add 3.8% Affordable Care Act surtax in most cases.
The Affordable Care Act surtax or NIIT (net investment income tax) is another 3.8%. This tax pertains to those filing single, with an income over $200,000, or married filing jointly with an income over $250,000. We don’t have an illustration of this computation as it is based on your unique tax and income situation.
Step-7: Add state taxes depending on where the investment property is located.
State taxes must also be incorporated into your capital gains. If your property is in New York state, where the rate is 8.82%, taxes on this $100,000 gain will be $8,820.
Calculating capital gains on the sale of a rental property is an involved procedure. To avoid skipping anything in the calculations and getting fined for it, it’s recommended to work with your tax advisor.
How to Avoid Capital Gains Tax on Rental Property?
There are several benefits to owning income-producing real estate, including recurring cash flow, long-term appreciation in market value, and lowering your taxable net income with ownership, business, and depreciation deductions.
Nevertheless, when the time comes to sell your rental property you may be in for a shockingly large tax bill. As experienced real estate investors know, what the IRS gives they’ll sooner or later try to take back.
Fortunately, there are four ways to reduce the amount of taxes you owe when selling a rental property:
- Tax-Loss Harvesting
Offsetting the gain from one transaction with the loss from another is referred to as tax-loss harvesting. This tax reduction approach is often employed by stock market investors, but you can also use it with rental property.
For instance, if you had a taxable gain of $60,000 from selling a rental property but can sell money-losing stocks for a loss of $50,000, you can decrease your taxable gain to just $10,000. If you have more losses than gains, you can carry-forward $3,000 each year to offset your ordinary income on federal income taxes.
- Installment Sale
If you own the property free and clear (devoid of any mortgage) you can also make use of an installment sale to decrease the amount of tax owed when you sell the rental property. With this approach, you still pay tax, but the payments are distributed out over a longer period of time.
Also referred to as a seller carryback or a seller-financed loan, an installment sale permits you to only pay taxes on the part of the gain associated with each payment you get from your buyer. Any interest you obtain from the buyer is treated as income.
Based on the purchase price and how your installment sale is designed, the profits from the sale may more than balance the number of capital gains from each installment sale payment.
- 1031 Tax-Deferred Exchange
Obviously, not every real estate investor has substantial losses in the stock market or intends to run the risk of making an installment sale, only to have to take the property back if the buyer defaults.
An IRS Section 1031 tax-deferred like-kind exchange is the ideal tool to utilize to defer your taxes on capital gains. The rules of a 1031 exchange permit you to sell or renounce one (or more) income properties and replace it with another, while entirely deferring the payment of any capital gains tax produced:
- Relinquished and replacement properties must be utilized for business or investment purposes.
- Real estate must be like-kind but can be a distinct asset class, like exchanging a commercial property for a residential property.
- Replacement property must be equivalent or greater in value than the relinquished property.
- All of the sales proceeds must be reinvested to prevent getting taxable “boot.”
- Name on the title of the replacement property must be the same as the name on the title of the relinquished property.
- Replacement property must be discovered within 45 days of the sale of the relinquished property.
- Replacement property must be bought within 180 days of the sale of the relinquished property.
- Transform Rental Property into a Primary Residence
The IRS doesn’t let you make use of your primary residence in a 1031 exchange.
Though, there is a way to transform your rental property into your primary residence and gain from the exclusion of capital gains tax on a primary residence proposed under the tax law:
- Rental property must be your primary residence for tax purposes, rather than a second home or vacation property.
- Rental property must not have been purchased through a 1031 exchange within the preceding five years.
- Rental property must be owned by you for at least two years.
IRS Section 121 allows you to exclude up to $250,000 in profits from the sale of your primary residence if you use a single filing status and up to $500,000 in profits if you are married filing jointly.
If you use this strategy to reduce the amount of tax from the sale of a rental property, be sure to speak with your financial advisor because the amount of deduction varies based on how long the property was used as a rental versus your primary residence.
Investing in real estate has always been one of the most useful ways to achieve financial independence. That’s for the reason that it offers amazing returns and even more incredible tax breaks.