Investing in real estate can be incredibly lucrative; however, you need to be well informed on all the financial aspects of real estate buying and selling in order to be successful.
For instance, if you intend to make a profit on your real estate investment, you need to know about capital gains taxes. Capital gains taxes can be complicated, however it’s essential to know the rules for capital gains taxes before you buy a new investment property.
What Is Capital Gains Tax On Real Estate?
In the context of real estate, capital gains tax is a tax that the government levies on any profit you make from capital assets. The “capital” refers to the money used for the investment. The “gains” refers to any profit you generate.
Not all capital gains are taxed the same way. There are many different taxation scenarios, and there are also several exemptions you may be eligible for.
Knowing what these scenarios and exemptions are can help you plan the sale of your property and limit the amount of capital gains taxes you are required to pay. The fewer taxes you have to pay, the more of the profit you get to keep!
Typical Scenarios Around Capital Gains
There are various capital gains tax scenarios that will arise when selling a property. One common scenario is that you sell the property for much more than what you bought it for.
This profit is called a capital gain, and the capital gains tax will only be levied on the gained amount beyond what you originally paid for the property.
The amount you’ll be taxed will be dependent on several factors, including how much profit you’ve made, whether or not the property you are selling is your primary residence, and how long you’ve owned the property for before selling it.
Short-Term Versus Long-Term Capital Gains Taxes
Capital gains tax is typically levied as either short-term or long-term capital gains tax. The difference between the two is how long you’ve owned the property before selling it.
Short-term capital gains tax refers to capital gains made within one year or less of buying the property. Long-term capital gains refers to capital gains made after you’ve owned the property for at least a year.
Short-Term Capital Gains Taxes
If you buy and sell real estate within a year and turn a profit, that profit will be considered the same as ordinary income and will be taxed as such.
For example, if you made $100,000 of regular income from full-time employment and made $20,000 on short-term capital gains, your total taxable income will be $120,000.
The amount you’ll have to pay in tax will depend on the tax bracket that you fall into. Depending on what your filing status is and the amount you’ve earned, you’ll have to pay a minimum tax rate of 10% and a maximum of 37% on your capital gains.
Long-Term Capital Gains Taxes
If you keep your property for at least a year before you sell it, your profits will be considered as long-term capital gains. Depending on what you earn, you may even be exempt from capital gains taxes.
For example, if you’re filing under a single status in 2022 and make $41,675 or less, the capital gains tax rate will be 0%. If you make between $41,676 and $459,750, the tax rate will be 15% on the income earned from that property. Anything above $459,750, and the tax rate will be 20%.
Capital Gains Tax Rates
Tax rates on capital gains are based on two primary factors: whether your gains are considered short-term or long-term, and your income level. Since short-term capital gains are taxed like ordinary income, we’ll go over how long-term capital gains are taxed.
Remember that these gains are for 2022 and will change year by year.
0% tax rate:
- Single filing status: up to $41,675
- Head of household: up to $55,800
- Married, filing jointly: up to $83,350
- Married, filing separately: up to $41,675
15% tax rate:
- Single filing status: $41,676 to $459,750
- Head of household: $55,801 to $488,500
- Married, filing jointly: $83,351 to $517,200
- Married, filing separately: $41,676 to $258,600
20% tax rate:
- Single filing status: more than $459,750
- Head of household: more than $488,500
- Married, filing jointly: more than $517,200
- Married, filing separately: more than $258,600
How To Calculate Capital Gains Taxes On Your Real Estate Investment Properties
At first glance, it might seem easy to calculate what you’ll owe on your capital gains. Simply subtract the amount you purchased the property from the amount you sold it for, right?
Well, not quite.
If you do it this way, then you’ll likely end up paying more tax than you have to. Instead, the first thing you need to do is calculate the cost basis of your investment.
The cost basis includes:
- How much you paid to purchase the property
- Costs related to the purchase, such as legal fees and some of the closing costs
- Costs of any renovations you made that added value to the property, such as a roof replacement, an addition, or a kitchen remodel (basic maintenance or cosmetic improvements are not included)
Once you have your cost basis, you’ll have to calculate your net proceeds.
You’ll do this by taking the sales price and subtracting the costs associated with the sale, such as:
- Costs of advertising the sale of your property
- Home staging and cleaning costs
- Real estate agent commission
- Lawyer fees
- Transfer taxes
Once you have made these calculations, subtract the cost basis from your net proceeds. This will give you the final figure at which you’ll be taxed. If you only use the price at which you bought the property and the price at which you sold it to determine your profit, then you’ll end up spending significantly more on capital gains taxes than you may need to.
Do You Have To Pay Capital Gains Taxes On Your Primary Home?
If the property you’re selling can be considered a primary residence, you can qualify for a capital gains exclusion. This means that you can exclude up to $250,000 in capital gains as a single or $500,000 if you file a joint return.
For example, if you earn $83,000 in capital gains as a single (calculated by subtracting your cost basis from your net proceeds), you won’t have to pay capital gains taxes on that amount as it is less than the $250,000 exclusion threshold.
However, to qualify for a capital gains exclusion, you must meet specific requirements. You will only be eligible if you’ve owned the property and used it as a primary residence for two out of the past five years.
Even if you rented out your property for the last two years, if you lived in the property for at least two out of the past five years then you can still qualify for the tax exemption.
There is also a capital gains tax exemption for serving members of the U.S. military on extended duty. If you meet the requirements, you’ll be able to suspend the five-year test period for up to a decade.
How To Reduce Your Capital Gains Taxes
Capital gains taxes can put a significant dent in your profit. This can have a big impact on your financial situation, especially if you are a real estate investor. Fortunately, there are several tactics that you can use to reduce your capital gains taxes.
Convert Your Investment Property Into A Primary Residence
Because there are capital gains tax exclusions available for primary residences, consider converting your investment property into a primary residence.
For instance, if you’ve owned a rental property for the past decade, moving into the rental property for two years will allow you to qualify for the exclusion.
Of course, this tactic only makes sense if time is on your side and you’re not in a hurry to sell.
Take Advantage Of Tax-Loss Harvesting
Tax-loss harvesting is a capital gains tax strategy that enables you to offset capital gains with capital losses. For instance, let’s say you purchased a property for $300,000. If you sold the property for $360,000, your capital gain would be $60,000.
With tax-loss harvesting, if you have any capital losses from other investments, you can reduce your tax by offsetting your capital gains with any capital losses.
For example, say you had capital losses of $25,000 from your other investments. You can use these capital losses to offset your capital gains, thereby reducing your taxable capital gains from $60,000 to $35,000 in this example.
Taking advantage of tax-loss harvesting can mean you’ll pay less in capital gains taxes.
Obviously, this only works if you’ve experienced a loss in one of your other investments.
Use 1031 Exchange To Defer Capital Gains Taxes
You can avoid paying capital gains on the sale of real estate by reinvesting your capital gains into another property under the 1031 exchange.
By doing so, you’ll defer what you owe on the capital gains taxes on the sale of your first property, and you won’t have to pay those taxes until you sell the second property you’ve just bought.
However, keep in mind that this only works for rental property investments. You cannot use this strategy on primary residences or vacation homes.
Hold Your Real Estate Investment For At Least A Year
You can save a substantial amount of money on capital gains taxes by simply holding on to any real estate you buy for at least a year.
Once you’ve owned a property for a year, any profits you make will transition from a short-term capital gains classification to long-term capital gains classification, thereby lowering the percentage at which your capital gains will be taxed.
As your capital gains will not be taxed as personal income, your profits will likely be taxed at a lower rate.
Invest In Qualified Opportunity Zones
The Tax Cuts and Jobs Act of 2017 established a new tax incentive for investors who invest in qualified opportunity zones.
An opportunity zone is a nominated area in the country where investments are eligible for certain tax exemptions. The goal behind this incentive is to encourage investors to spend in regions that need it most in order to promote economic growth.
If you invest your capital gains from a real estate sale into an opportunity zone fund, you can defer your capital gains taxes for up to eight years. Moreover, if you hold your investment for at least a decade, you’ll receive a full exemption from any capital gains taxes on all capital gains you make in the future on that opportunity zone fund.
Invest In Real Estate Through An IRA
Individual Retirement Accounts (IRAs) allow you to invest in various assets, including stocks, bonds, Exchange Traded Funds (ETFs), mutual funds, and even real estate. You must have a self-directed IRA to invest in real estate. Moreover, any real estate that is purchased must be strictly an investment property.
Like other assets in your IRA, the sale of the real estate will be either tax-free or tax-deferred (depending on the setup of your IRA). If you invest in a rental property, all rental income will be classified as tax-free inside your IRA.
Essentially, any profit you make from real estate bought through your IRA will remain in your IRA and won’t be taxed until you begin making withdrawals (and you’ll only be taxed on the amount you withdraw). In the case of some ROTH IRAs, investment gains are tax-free.
What Is Depreciation Recapture?
If you’ve bought an investment property, you can claim a depreciation deduction every year. Doing so can reduce the amount of tax you’ll have to pay on your rental income. The amount you can deduct is equal to your property’s cost basis divided by 27.5.
For example, if you spend $200,000 to purchase a rental property, then you’ll be able to deduct roughly $7,272 for depreciation from your rental income every year.
As you can see, this is an enormous benefit. However, it’s critical to know that you’ll owe a depreciation recapture tax if you sell your investment property for a profit. The depreciation recapture is a tax on all of the deductions you made.
The drawback of the depreciation recapture tax is that it’s based on your income tax rate instead of the capital gains tax rate, and can range up to 25%.
Continuing the example, if you held your rental property for a decade and wrote off a total of $72,727 in depreciation deductions, you would owe roughly $18,181 in depreciation recapture tax (if you owed the maximum amount).
You could avoid the depreciation recapture tax by not taking yearly deductions; however, you’ll likely save more money over the long term by taking the deductions.
There are a few ways that you can avoid the depreciation recapture tax. For example, by turning the property into a primary residence before selling or by using the 1031 exchange.
Understanding Capital Gains Taxes Is Essential To Successful Real Estate Investing
An investment property is designed to generate income and grow wealth. To be successful, it’s important to minimize expenses and maximize your profit.
Therefore, an understanding of the capital gains tax can be advantageous for your bottom line. Knowing your predicted capital gains at selling time can help you plan and implement various tax-saving strategies today.