If you’re like many people, you know that owning a rental property comes with several benefits – it diversifies your portfolio, brings in passive income and even gives you a few tax benefits. In fact, there are even ways to avoid capital gains taxes on rental properties. Naturally, you should speak to a financial adviser before you sell a rental property, and this doesn’t constitute tax advice; you should consult a tax professional for that. However, here’s a quick run-down on capital gains taxes and how they apply to your rental property.
Can You Avoid Capital Gains Taxes When You Sell a Rental Property?
In some cases, people are able to avoid capital gains taxes when they sell a rental property. Capital gains are the net profits you realize when you sell a capital asset, such as a rental property; the Internal Revenue Service taxes you on them. Essentially, the adjusted basis (what you paid for the house) minus the realized sales price (the amount you sold the house for) equals your capital gain or loss.
The amount you pay in capital gains tax has a direct correlation to how long you owned the asset before you sold it. There are two major types of capital gains tax:
- Short-term capital gains tax. The short-term capital gains tax is paid on profits you made from selling a rental property that you owned for a year or less. This tax is in the same bracket as your everyday income tax is.
- Long-term capital gains tax. Long-term capital gains tax applies to rental properties that you owned for more than 12 months. Long-term capital gains tax rates are usually lower than short-term capital gains tax rates; the rates are 0 percent, 15 percent and 20 percent, and yours will depend on your filing status and taxable income.
How Much Capital Gains Tax Will You Pay on the Sale of an Investment Property?
The IRS calculates capital gains this way:
- You pay 0 percent if the taxable income is below $80,000
- You pay 15 percent if the taxable income is between $80,000 and $441,450 when you file as a single payer
- You pay 15 percent if the taxable income is between $80,000 and $496,600 when you file as a qualifying widower or married filing jointly
- You pay 15 percent if taxable income falls between $80,000 and $248,300 when you file as married filing separately
- You pay 20 percent if taxable income exceeds the limits set for the 15 percent capital gain rate – and in some cases, you could end up paying more than 20 percent.
However, you may be able to avoid capital gains taxes if you deduct operational losses from your taxable income. You should absolutely consult with a tax professional if this is a route you’re interested in taking – your tax pro will be able to give you the best (and most current) advice.
You may also consider a 1031 exchange. In a 1031 exchange, you defer paying capital gains tax by agreeing to use the profits you make from the sale of a rental property to buy another “like-kind” property. These can be tricky – and you have to move quickly (you have 45 days to find a replacement property, for example), so it’s best to work with an experienced REALTOR® on a 1031 exchange.
The other ways you may be able to avoid these taxes is by changing the property from a rental to a primary residence or by deducting fees from the realized sales price (such as those related to home improvements, like upgrading windows and installing a new roof).
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