Capital Gains on Rental Property: What Investors Need to Know

Real estate investing offers the prospects of making money, building wealth, and growing an impressive portfolio. You've worked hard to maximize the returns on those investments, and the last thing you want is to make decisions that cut into your profits and derail your business plans.

When you own rental properties, you can strategically reduce your taxable income through operational expenses and deductions. But what happens when it's time to sell? That's where understanding capital gains for rental property comes in.

We'll share with you how you can leverage various strategies to reduce your capital gains taxes and increase your profits when you sell. This article breaks down the difference between short vs. long-term capital gains and lays out options to slash your tax liability so you can keep plowing more money back into new investments.

Get ready to learn the smart moves to hold onto more of those hard-earned investment earnings.

Understanding capital gains taxes

If you sell assets like stocks, bonds, or real estate, the government levies capital gains taxes on the profit between what you paid for the assets and what you sold them for. These are capital gains taxes.

These taxes generate revenue for the government and discourage frequent trading or flipping of assets solely for short-term gains. By taxing these profits, the government aims to promote long-term investment and discourage speculative behavior that could destabilize financial markets.

Short-term capital gains, which are profits from assets held for one year or less, are taxed as ordinary income at your marginal tax rate. Long-term capital gains, which are profits from assets held for more than one year, are typically taxed at lower rates ranging from 0% to 20%, depending on your taxable income.

The good news for real estate investors is that there are various parts of the Internal Revenue Service (IRS) code that allow you to reduce or defer these taxes on real estate. 

How much will capital gains taxes cost you?

The amount of capital gains taxes you pay depends on several factors, including the type of capital gain (short-term or long-term), your income level, and the country or jurisdiction in which you reside. There are two types of capital gains taxes:

1. Short-term capital gains tax

If you sell a rental property you've held for less than a year, your profits will be subject to short-term capital gains tax. Short-term capital gains get taxed at ordinary income tax rates — these are the highest tax rates you pay.

Currently, these rates range from 10% to 37%, with your specific rate determined by your overall income tax bracket for that year.

2. Long-term capital gains tax

If you sell an investment property after a year, your capital gains taxes now fall under long-term capital gains. These taxes have different rates, which are generally lower than those for short-term gains.

Current tax rates for long-term capital gains are as follows:

• 0% tax rate: If your income is up to $44,625 for single filers or up to $89,250 for married couples filing jointly.
• 15% tax rate: This is the most commonly applied rate. It applies to estate investors with income between $44,626 and $492,300 for single filers or between $89,251 and $553,850 for married couples filing jointly.
• 20% tax rate: This rate applies to incomes above $492,300 for single filers and $553,850 for married couples filing jointly.

Reducing capital gains taxes

So what can real estate investors do to reduce capital gains taxes on investment profits? There are many options in real estate investing, and reducing your taxes is one of the biggest benefits to help build wealth. Here's what you can do:

Hold assets long-term

Consider holding the asset for more than one year. This approach aligns with long-term investment strategies and takes advantage of lower tax rates for long-term capital gains. While it might not work for home flippers who rely on quick turnovers and face immediate financial pressures, this strategy helps other real estate investors minimize their tax liabilities.

Offset gains with capital losses

If you have rental properties in your portfolio that aren't performing, it can be a good idea to sell them during the same year you expect to have a capital gains tax liability. This strategy is called tax-loss harvesting. Using this approach, you can sell underperforming real estate assets at a loss to reduce the taxable gains from more successful investments.

Invest in opportunity zones

One way to temporarily avoid capital gains tax is by investing in designated Opportunity Zones. These zones are economically distressed communities where new investments may be eligible for preferential tax treatment. Here's how this works:

• Invest in a QOF: Sell your rental property at a profit and invest the proceeds in a Qualified Opportunity Fund (QOF).
• Defer taxes: Defer taxes on the prior gains invested into a QOF until the investment is sold or exchanged or until December 31, 2026, whichever comes first.
• 5-7-year holding benefit: If you hold the QOF investment for more than five years, 10% of the deferred gain gets excluded from your capital gains taxes. If you hold it for more than seven years, the exclusion increases to 15%.
• 10-year hold: For investments you hold for at least 10 years, the basis of the QOF investment increases to the fair market value at the time of sale or exchange. This longer hold time frame could potentially eliminate taxes on capital gains from the QOF.

Rental conversion to primary residence

One smart strategy to reduce capital gains taxes is to convert a rental property into your primary residence before selling. By living in the property as your main home for at least 2 out of the 5 years preceding the sale, you may qualify for the home sale exclusion.

This allows single filers to exclude up to $250,000 and married couples filing jointly to exclude up to $500,000 of the capital gains from taxation.

There's no limit on how many times you can use this exclusion. The only requirement is that you can't claim it more than once every two years.

Use a 1031 exchange

When it's time to sell an investment property, you can avoid paying capital gains tax by rolling over the proceeds into another property through a 1031 exchange. This is an amazing strategy to build wealth in real estate because there's no limit to how many times you can do this.

Think about this example: you bought a single-family rental and then sold it. Instead of pocketing the profits and paying taxes, you rolled all the proceeds into a larger multifamily property. You get to defer those capital gains taxes, and now you've got a bigger rental income stream from the larger property.

Here’s how it works:

• Eligibility: You must use both the property sold and the property purchased for investment or business purposes.
• Timing: You must identify a replacement property within 45 days of selling the original property and complete the purchase within 180 days.
• Intermediary: A qualified intermediary must hold all proceeds from the sale to verify the exchange is valid.
• Continual deferral: By repeating the process, you can defer capital gains taxes indefinitely until you decide to sell the property outright without reinvesting.

Maximize deductions

Be sure to maximize your deductions each year to help reduce your tax liability. Here’s how you can implement this strategy:

• Depreciation: Deduct the cost of the property over its useful life as defined by the IRS. This provides you with a large annual deduction.
• Interest: Deduct mortgage interest paid on loans used to purchase or improve rental properties.
• Repairs and maintenance: Immediately deduct expenses for repairs and maintenance that enhance your property's value and operational status.
• Property taxes and insurance: Deduct property taxes and insurance premiums related to your investment properties.
• Professional fees: Deduct fees for legal and professional services like property management, accounting, and legal counsel.
• Travel expenses: Deduct travel expenses incurred to visit and buy new properties.

Installment sales

You can also use installment sales to reduce your capital gains tax. This method involves spreading out the proceeds from a property sale over multiple years. Instead of one lump sum from a sale, you receive payments in installments. This defers your tax liability and potentially keeps you within a lower tax bracket.

You might hear these referred to as:

• Seller financing
• Seller carryback
• Land contract
• Contract for deed

Other tax considerations

You may have other taxes when selling a rental property, including:

Depreciation recapture tax

During the time you hold an investment property, depreciation expense is a big benefit because it reduces your taxable income without being a "real" out-of-pocket expense. It’s an accounting method that allows you to deduct a portion of the property’s cost each year to account for wear and tear without actually costing you money. However, when you sell a rental property, unless you do a 1031 exchange, you'll have to pay depreciation recapture tax.

If you sell a property for more than its depreciated value, you may have to "recapture" some of the depreciation you've claimed. Essentially, the IRS taxes the part of the sale price attributable to the depreciation deductions you took.

Typically, you recapture depreciated real estate at a rate of 25%, which is higher than the long-term capital gains rate for most taxpayers but lower than the ordinary income tax rate.

This tax impacts your profit by reducing the benefit of the depreciation deductions and increasing your tax liability upon the sale.

State income tax

You may also have state income tax on your profits. The specifics of this tax depend on the state where the property resides since each state has its own tax laws and rates.

Some states, like Florida and Texas, do not have a state income tax. Others, such as California and New York, impose higher rates that can significantly impact the total tax burden from the sale of a property.

Net investment income tax (NIIT)

NIIT is an additional tax of 3.8% that applies to certain investment income of higher-income individuals, estates, and trusts. This tax affects you only if your income is above these levels:

• $200,000 for single filers.
• $250,000 for married couples filing jointly.
• $125,000 for married individuals filing separately.

If your income is at these levels and you make money from investments, you might need to pay this extra tax to help support healthcare costs under the Affordable Care Act.

Capital gains on rental property

Real estate investing is about making smart moves to maximize profits and grow wealth. When it comes time to sell your investment properties, you don't want the tax man taking an oversized bite out of your well-earned gains.

Knowing the capital gains landscape and using strategies like 1031 exchanges can help you significantly reduce your tax burden. And don't forget about the home sale exclusion, either: it can provide major savings if you convert a former primary residence to a rental.

The key is being proactive and purposeful with your tax planning from the start. Get strategic about minimizing capital gains exposure so your investment profits can keep compounding year over year. Stay on top of the rules and latest tactics, and you'll be growing that real estate empire in no time. Time to start making your money work smarter, not harder.

Capital gains rental property FAQs

How do you avoid depreciation recapture on rental property?

To avoid depreciation recapture on a rental property, use a 1031 exchange to reinvest the proceeds into another investment property.

How do you calculate capital gains on a rental property?

To calculate capital gains on a rental property, subtract the property's purchase price plus any improvements from the selling price. Then, subtract any expenses related to the sale, such as real estate commissions and legal fees.

What is a simple trick for avoiding capital gains tax on real estate investments?

A simple trick for avoiding capital gains tax on real estate investments is to use the property as your primary residence for at least two of the five years before selling it. This qualifies you for the home sale exclusion, potentially eliminating a significant portion of the capital gains tax.