America has a progressive federal income tax system, meaning those who earn more pay a higher percentage of their income as tax, while those who earn less pay less. But many people don’t realize that when they reinvest after-tax money in things like stocks or real estate, and that investment generates a profit, the profit is also subject to taxation. This is called a capital gains tax, and like everything else having to do with the tax code, it only gets more complicated from there.
You pay a capital gains tax when you sell a capital asset, such as shares of a publicly traded company or a rental property that you own, for more than you paid for it – plus or minus certain adjustments. For example, if you purchased stock in a company 5 years ago for $10,000 and sold it this year for $20,000, the $10,000 profit would be subject to federal capital gains tax and possibly state tax as well, depending on where you live.
The same principle applies to your rental property, such as a second house that you rent to others. Understanding how different factors effect capital gains on rental properties can help you mitigate or even eliminate the tax you’ll pay after you sell.
Short-term capital gains are the profits realized from the sale of an asset, such as a rental property, within the first year after you first acquired it. The short-term capital gains tax is similar to the tax on your regular income, between 10% and 37% – the rate gets higher as your taxable income gets higher.
Long-term capital gains are profits you realize from the sale of an asset you’ve held for more than 1 year. Long-term capital gains are taxed at 0%, 15% or 20% depending on your taxable income.
There are ways to reduce or even eliminate your tax liability on the capital gains you make from the sale of a rental property. Before undertaking any of these actions, you should consult with a trusted tax advisor to make sure all contingencies are considered. Here are your options.
Section 121 of the Internal Revenue Code allows you to reduce or eliminate capital gains tax by converting your rental property to your primary residence before selling if:
Many real estate investors engage in 1031 (like-kind) exchanges. In a 1031 exchange, a real estate investor sells their current property but then rolls the proceeds into a new investment opportunity and postpones their capital gains taxes indefinitely.
Another alternative available to longtime real estate investors with large capital gains tax liabilities is to transfer those assets into an opportunity zone. Investors begin to enjoy a step up in basis after 5 years. After 10 years, the gains become tax-free.
If you have an investment portfolio in addition to your rental property, you might be able to use losses in the portfolio to offset your capital gains tax when you sell the property. The losses reduce your overall taxable capital gains and potentially offset some of your taxable income. You can then use the money from the sale of the underperforming securities to invest in a different security. A good financial advisor will make an annual assessment of your portfolio and determine if there is a viable tax loss harvesting strategy available.
If you own the property for less than a year before selling, any gain is considered a short-term capital gain, which is taxed like your regular income. If you owned the property for more than a year, the profit is considered a long-term capital gain, which is generally lower than income tax and may even be zero.
There are lots of ways you can reduce your tax liability on capital gains realized from sale of a rental property. These will require you keep all records from the original purchase of the property and a detailed accounting of all expenses you incurred related to the property. You’ll also need a good tax advisor.
Rental property depreciation is a basic accounting principle that allows you to deduct the cost of a rental property over a set period of time. The IRS assumes a rental property will lose a certain amount of value every year (typically 3.6%). For as long as you own the property, this loss, also known as depreciation, can be subtracted from your taxable income every year. This, in turn, can lower your taxes and may even drop you into a lower tax bracket. If you own a rental property, the federal government allows you to claim the depreciation of the property every year for 27.5 years.
You can earn tax deductions for all qualified expenses on your property, including mortgage interest payments, maintenance, insurance, travel, professional services, eviction-related expenses and more.
The property basis is the amount of your capital investment in the asset for tax purposes. To determine the basis of your property, begin by noting the cost of the original investment that you made in it. Next, add in the cost of major improvements (for example, additions or upgrades). Then, subtract any amounts allowed via depreciation or casualty and theft losses. There are any number of capital improvements you can make over time to bring up the basis.
Here's an example of how increased basis reduces your tax. Say you buy a property for $100,000, keep it for 10 years and are about to sell it for $300,000. That would qualify as a long-term capital gain of $200,000. However, if you have detailed, documented evidence that you have made $125,000 in capital improvements to the property, your capital investment is effectively $225,000. Your capital gain is now reduced to $75,000.
There are several ways you can avoid paying tax on gains you make from the sale of a rental property. As described in more detail above, they include converting the property to your primary residence, harvesting tax losses from other assets you own or rolling your gains into another investment through a 1031 exchange. Depending on your personal and financial situation, some or none of these options may be available to you.
If you sell the property for more than you paid for it, you will likely have to pay some tax on the difference. If you owned the property for less than a year, your profit is deemed a short-term capital gain and is usually taxed at the same rate as your other income. If it’s more than a year, you have a long-term capital gain that is taxed at 0%, 15% or 20% depending on your taxable income. Your financial advisor and tax advisor may have ideas for ways to reduce or eliminate your capital gains tax liability.
As discussed above in detail, with some good financial strategy there are ways you can reduce the amount of capital gains tax you’ll pay after selling. These include deductions for depreciation and any qualified expenses you’ve incurred while owning the property, as well as boosting the property’s basis with documentation of any capital improvements you’ve made to it.
People often try to avoid paying short-term capital gains, which are taxed at a higher rate than long-term, by holding on to the property for longer than 1 year. While short-term capital gains can increase your tax bill, it might be the best strategy to sell and pay them when the gains are worth it.
You may find that owning a rental property is an excellent way to supplement your income. First, assuming you set the monthly rent at significantly more than your monthly mortgage payment on the property, your rental can provide steady and predictable income. Second, if the value of the property increases over time, you can sell and keep the profit.
The profit is considered a capital gain, and you most likely will have to pay tax on it. Understanding how different factors affect your capital gains exposure on the sale of rental properties can help you mitigate or even eliminate the tax you’ll pay after you sell.
If you’re ready to get started in real estate investing, you can start the mortgage application process with Rocket Mortgage ® right now.
David Collins is a staff writer for Rocket Auto, Rocket Solar, and Rocket Homes. He has experience in communications for the automotive industry, reference publishing, and food and wine. He has a degree in English from the University of Michigan.
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