How to Avoid Capital Gains Tax on a Rental Property

  • Apr 16, 2024
  • 5 min read
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Did you know that more than ten million Americans earn income from rental properties? With so much potential to earn passive income from real estate investing, it is no surprise.

However, if you want to become a rental property owner and cash in on the profits, there’s one thing you must understand: taxes. Specifically, income taxes and capital gains taxes.

This article will discuss capital gains and how to avoid capital gains tax on rental property. Continue reading to learn more.

What Are Capital Gains on Rental Properties?

According to the Internal Revenue Code (IRC), capital gains tax is the tax you pay when you sell a capital asset for more than you paid for it (cost basis).

For instance, if you bought a single-family home in 2017 for $350,000 and sold it in 2021 for $500,000, the capital gain would be $150,000.

Examples of capital assets include:

  • Art collectibles
  • Bonds
  • Cars
  • Properties
  • Stocks
  • Other investments

Under Internal Revenue Service (IRS) tax laws, capital gains have different tax rates, ranging from 0-37%. Several factors determine your tax rate when you sell a capital asset.

While paying capital gains tax may seem like a financial loss, don’t let it scare or discourage you from investing in real estate; the tax benefits of owning a rental property still outweigh the need to pay capital gains tax. With the number of tax deductions you receive and how you can offset capital gains tax, investing in real estate is worthwhile.

Short-Term Capital Gains

Short-term capital gains are the profits you realize when you sell an asset within the first year of owning it.

The short-term capital gains tax rate is the same as the rate of your regular income tax bracket. Income tax rates range from 10% to 37%, depending on your income level and filing status.

For example, if your status is “married filing jointly,” the ordinary income tax rate is as follows:

  • 10% – $0 to $23,200
  • 12% – $23,300 to 94,300
  • 22% – $94,300 to $201,050
  • 24% – $201,050 to $383,900
  • 32% – $383,900 to $487,450
  • 35% – $487,450 to $731,200
  • 37% – $731,200 and above

If you file as “single,” “married filing separately,” or “head of household,” the tax brackets remain the same, but the income amounts change.

Long-Term Capital Gains

Long-term capital gains are the profits you realize when you sell an asset after the first year of owning it.

The long-term capital gains tax rate is either 0%, 15%, or 20%, depending on your taxable income.

How to Avoid Capital Gains Tax on a Rental Property Sale

Capital gains may seem like a tax burden. However, several legal ways exist to avoid capital gains on an investment property. Check them out below.

Manage the Sale Date

It’s possible to lessen your tax burden by controlling the tax year you report the taxable capital gains. You may avoid paying your minimal capital gain if you can transfer ownership in a year when you expect to have lower taxable income.

Keep in mind that you can’t just sell a property and change the year you sold it to fit your needs. This strategy requires careful planning to understand when you may have a lower taxable income, so you know in which year to sell your property.

The Section 1031 Exchange

A 1031 exchange allows real estate investors to sell their rental property but roll the proceeds into a new one. However, the new property must have the same purpose. You cannot sell a rental property and move the proceeds into a primary residence.

The IRS calls this a tax-deferred exchange or a like-kind exchange. Think of it as buying a replacement property.

Alternatively, longtime investors with significant tax liabilities can transfer their assets to an opportunity zone. After five years, they will enjoy a step up in basis, and after ten years, the gains become tax-free.

A step up in basis in real estate is when a property’s cost basis resets to match its fair market value (FMV) rather than the original purchase price.

Offset Gains with Losses

Tax-loss harvesting is when you reduce your tax burden by pairing the capital gains from selling one asset with the capital losses of selling another.

This is a strategy many tax professionals use to help their clients reduce their capital gains tax liability.

Leverage Section 121 Primary Residence Exclusion

IRS Section 121 allows single taxpayers to exclude capital gains of up to $250,000 from the sale of their primary residence. The exemption is up to $500,000 for married couples who file jointly. These tax exclusions don’t apply to the sale of a rental property. Thus, converting a rental property to a primary residence could help you avoid capital gains tax.

To qualify, the homeowners must’ve lived at the property as their primary residence for two of the five years immediately before the home sale.

How to Reduce Capital Gains Tax on a Rental Property

Even when you can’t avoid capital gains tax, there are other ways to at least reduce your tax bill. Examples include:

  • Subtracting the depreciation deduction (also known as depreciation recapture) from your tax bill
  • Deducting qualified expenses like mortgage interest payments, maintenance, professional services, closing costs, and more
  • Increasing the property’s cost basis

You could also avoid capital gains tax on an investment property by purchasing it with a retirement account, like an IRA.

When in doubt, work with a tax advisor who is proficient in understanding the tax code. They can help you navigate all things real estate finances, from helping you file your tax return to answering questions like, “How is rental income taxed?”

Work With All County Property Management

When you know how to avoid capital gains tax on a rental property, it makes real estate investing more lucrative.

If you’re already a property owner looking for assistance managing your property, let us help. Find a property manager from All County today and take the hands-off approach to rental property ownership. Not only will we handle all landlord duties for you, but we also have financial professionals on our team to help you tackle your taxes.

So reach out now, and let’s turn your property into a steady stream of passive income.

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