Avoiding Capital Gains Tax on Rental Property and Real Estate Investments

The PropertyClub Team
Aug 14th 2020
As with any investment, one of the things to think about when purchasing a rental property is your exit strategy. Here's what you need to know about how you can avoid some capital gains tax on the sale of your real estate.

Rental properties can prove to be a fantastic source of income, even during times of economic turmoil. Income generated from real estate investment properties, especially rental houses or apartments, is relatively stable due to the long term nature of most leases. This is why many Americans decide to invest in real estate. However, there are times when you'll want to sell your rental property, and one of the biggest burdens can be the capital gains tax. 

If you’re at the point where you no longer feel that a rental property serves you, the only option you have is to sell it. Unfortunately, one thing can prove to be a huge impediment to people who want to maximize their “exit sale,” and that’s the capital gains tax. If you’re wondering how it’ll affect you and how to avoid it, this article is for you. 

What Is The Capital Gains Tax?

Capital gains taxes are special taxes you pay when you sell an investment vehicle, such as a rental property. They come in two “flavors” ---long-term and short-term capital gains. 

A long-term capital gains tax kicks in if you’ve held the investment vehicle for more than a year. A short-term tax applies when you hold the investment for under a year. 

Understanding How The Capital Gains Tax Works

To understand how you can avoid getting hit with a capital gains tax, it’s crucial to know how the IRS treats its tax system. When dealing with the sale of a real estate investment property, you don’t immediately get slapped with a tax percentage. There are a slew of calculations that come out of it. 

Calculating Capital Gains

Capital gains are calculated by how much value your investment property has increased by since you first bought it. If you purchased your rental property for $100,000 and you chose to sell it at $300,000, you had $200,000 in capital gains. 

However, you can subtract some of the costs and expenses of selling the investment property from your overall profits, lowering your capital gains tax bill. 

Capital Gains Tax Rates

How long you’ve kept your rental property matters a lot when it comes to avoiding heavy taxation. 

Short-term capital gains taxes are known for being hard on the wallet, and they have tax rates that mimic regular income. This means you can pay 10%, 12%, or even as much as 37% if you sell your home after only a year of using it. 

The IRS loves to see long-term investment. If you keep your home for longer than a year, your tax rates can drop to 0%, 15%, or 20%, depending on how much you earn. Most people will have a capital gain between $40,000 and $434,500 for a home sale. This lands them squarely in the 15% range.

Depreciation Recapture

Another factor that can come into play with your capital gains tax bill is depreciation recapture. This is the IRS’s way of getting back the non-cash depreciation value you may have written off over the years. 

The IRS measures out home depreciation over the course of 27.5 years. Each year that you own the rental property is another year of depreciation recapture that you will have to tack onto your bill. You can read more about this on the IRS tax site, or better yet, ask an accountant.

How You Can Avoid Capital Gains Taxation When Selling Rental Property?

If you made a killing on selling your rental property, you can expect your capital gains tax bill to be pretty high. Thankfully, there are ways to reduce or even entirely avoid your tax bill altogether. This section will show you how to make the most of your filings when selling real estate investment property. 

Capital Gains Write-offs For Primary Residences

The most common way to avoid getting hammered at tax time is to write off a large portion of your rental property by converting it to a primary residence. For people who are not afraid to move in for a while, this can offer up a significant deduction. 

The IRS gives you a little leeway when it comes to how much money you will have to pay if you’re choosing to move to your rental home full-time. The rules here are different for singles and married individuals. Here’s what you need to know:

  • Singles can write off the first $250,000 of capital gains on real estate. 
  • Married couples can write off the first $500,000 of capital gains on real estate.

To get this write off, several things have to be true. First, you have to live there for at least two out of five years before selling it. You also have to own the house for a minimum of two years before putting it on the market. Finally, if you choose to use this route, you cannot have excluded capital gains taxes in the past two years. 

Using A 1031 Exchange to Purchase Another Investment Property

Let’s say that you sold your rental property so that you could buy a bigger investment property on the 1031 exchange. With this situation, the IRS allows you to see this as a tax deferment since you’re using that money to get another property of equal or greater value. 

Noting Non-Cash Depreciation Expenses

Non-cash depreciation expenses are not notable on your income, primarily because they didn’t involve a cash transaction. Instead, these expenses are meant to note the gradual decrease in the value of certain items and fixtures in your home. 

For example, let’s say that you have a boiler in your home. When you bought the property, it was brand new. That was ten years ago. You can subtract how much that boiler’s value has depreciated as part of your overall filing. 

Tax Harvesting

If you have multiple properties, you might want to do some tax harvesting. This requires you to sell one home at a loss to offset capital gains of another. This can be a good option if you don’t mind missing out on that other house. 

Adding Business Expenses

Let’s be honest. Having a rental property has its expenses. It is a business, after all. That’s why an excellent way to reduce paying too many taxes involves writing off business expenses relating to your rental property. 

Some of the common expenses people write off include property management company use, travel to check up on their investment property, bills from maintenance specialists, and advertising costs. When in doubt, ask your accountant what expenses you can write off. 

Mortgage Interest Deduction

Another way to reduce your gross income is to add in mortgage interest expense deductions into your filings. This is a simple way to quickly dispense of some seriously high bills in many situations. 

Adding Rental Property Improvement Expenses

Along with regular operating costs, choosing to add a little extra flair to your rental property can prove to be an advantageous choice come tax season. Some of the more popular write-offs under this category include:

  • Installing New Flooring
  • HVAC Upgrades
  • Kitchen Remodeling

Increasing Property Basis

Technically, home improvement projects can also increase your property basis while lowering capital gains earned. However, there’s a lot more to this term than just home improvements. This umbrella of expenses also covers things that occurred during the sale, such as:

  • Appraisals And Inspection Fees
  • Closing Costs
  • Real Estate Commissions
  • Legal Fees
  • Title Search Fees
  • Escrow Fees
  • Closing Costs

If you sold your investment property, you have at least a thousand or so to write off, right off the bat. 

Capital Loss Deductions

Let’s say that, for some of the years where you had your home, the real estate market tanked. It happens, and when it does, you actually can get a little help on your taxes. If your investment property suffered a loss during any year, you can use those losses as a deduction on your taxes. 

The IRS puts a limit of $3,000 per loss deduction per year, though they don’t have a limit on how many years you can place a loss. So while this can chip away at the overall tax bill, it probably won’t eliminate it. 

Additional Advice

The thought of having to pay thousands in capital gains taxes would make almost anyone recoil in fear. It’s normal to feel like you might be out of a lot of money, but it doesn’t have to be that way. If you’re still feeling lost about your filings, the best thing you can do is reach out to a local expert like a real estate agent or an accountant. 

Taxes are no joke and shouldn’t be a matter that you take lightly. While this article offers a little insight into how people can avoid capital gains, the best thing you can do is to discuss the matter with professionals who have helped others in your situation. After all, they have the knowledge and experience to ensure that you can maximize your profits.