Investing in rental properties is a great way to generate passive income, but it also comes with a few tax considerations. Namely, you’ll need to pay capital gains tax on any profit you make when you sell the property.
Unfortunately, taxes are a necessary evil when it comes to investing, so you’ll need to account for them when performing your investment analysis and running the numbers on your potential profits.
What are Capital Gains Taxes?
Capital gains tax refers to the tax you have to pay when you profit from selling an asset that has increased in value. Assets such as real estate, stocks, and bonds can all increase in value over time, and if you sell them for more than you paid for them, you will owe capital gains tax.
The amount of tax you owe will depend on the profit you generated, your tax bracket, and how long you held the asset. With that in mind, there are two types of capital gains taxes: short-term capital gains and long-term capital gains.
Short-Term Capital Gains on Rental Properties
Short-term capital gains occur when you sell an asset that you have held for less than one year. These gains are taxed as regular income, which means they will be taxed at the federal income tax rate that applies to your tax bracket.
For example, if you are in the 25% tax bracket based on your personal income, then your short-term capital gains will be taxed at 25%. Most rental property investments aren’t subject to short-term capital gains taxes because they are typically held for longer than a year.
However, fix-and-flip investments or other short-term investments are generally subject to short-term capital gains. This is because fix-and-flip investors are typically looking to make a profit as quickly as possible by buying properties, fixing them up, and selling them right away. The faster they can flip a property, the more profit they will generally make.
Long-Term Capital Gains on Rental Properties
Long-term capital gains occur when you sell an asset that you have held for more than one year. These gains are taxed at a lower rate than regular income, which can make them much more favorable from a tax perspective.
The long-term capital gains tax rates are 0%, 15%, or 20%, depending on your overall tax bracket. If you’ve invested in a rental property, odds are you’ll be subject to long-term capital gains taxes since few investors sell their rental property in less than a year from the purchase date.
Cost Basis For Computing Your Capital Gains Tax
The cost basis is the original value of an asset for tax purposes. When you calculate your capital gains tax, you will need to take into account the cost basis of the property in order to determine how much profit you have made. It’s important that you understand what will increase and decrease your cost basis since this will affect the amount of tax you owe.
What Can Increase Your Cost Basis
The cost basis isn’t just the original purchase price of the property. There are a number of things that can increase your cost basis, which will in turn lower your capital gains tax bill.
The following are a few of the costs associated with real estate investing that will add to your cost basis:
- Inspections and appraisal fees: The cost of an inspection or an appraisal can be added to your overall cost basis.
- Recording fees and owner’s title insurance: These are the costs associated with officially recording the purchase of the property, which can also be added to your cost basis.
- Real estate commission: Any commissions that you pay to a real estate agent from the sale of your rental property can be added to your cost basis.
- Cost of additions and improvements: Any renovations and repairs that you complete on the property can be added to your cost basis.
- Assessments that increase the property value: An assessment that increases the value of your property, such as a rezoning that allows for more development, can be used to increase your cost basis.
What Can Reduce Your Cost Basis
There are also a number of things that can reduce your cost basis, which will in turn increase your capital gains tax bill. The following are a few of the items that can be deducted from your cost basis:
- Depreciation: Depreciation refers to the wear and tear that occurs to a property over time. This can be deducted from your cost basis, which will in turn increase your capital gains tax liability. However, only the value of the structure can be depreciated, not the land.
- Amount received for granting an easement: An easement is the right to use someone else’s property for a specific purpose. If you grant an easement on your rental property, then the amount you receive for doing so will be deducted from your cost basis.
- Casualty or theft loss deductions: If you’ve written off any casualty or theft losses on your rental property, then those deductions will be subtracted from your cost basis.
Other Figures Needed To Calculate Capital Gains Tax
In addition to the cost basis, there are a number of other figures that you’ll need to take into account when calculating your capital gains tax, including your net proceeds and your tax rate.
The net proceeds refer to the total amount of money that you receive from the sale of your property after subtracting any selling expenses, such as real estate commissions or closing costs.
The amount you’ll be taxed depends on a variety of factors. For example, if you have owned the property for less than a year before selling it, you’ll be subject to your ordinary income tax rate.However, if you have owned the property for more than a year, you’ll be subject to a lower capital gains tax rate that is based on your income tax bracket. You’ll need to determine whether your capital gains are short-term or long-term and which tax bracket you fall into and to identify what your tax rate will be.
How It All Ties Together
At first glance, all of the different factors that contribute to what you’ll owe on your capital gains taxes may seem confusing. As such, it’s best to break it down by the type of real estate investment you’ve made:
Short-Term Capital Gains: The Fix-And-Flip
If you’re in the business of flipping properties, then your capital gains taxes are going to be a bit different than someone who is holding on to a property for the long term. When it comes to fix-and-flips, your main concern should be short-term capital gains taxes, as that is what you’ll be subject to if you sell the property within a year of purchasing it.
To calculate your short-term capital gains taxes on a fix-and-flip, you’ll need to first figure out your cost basis. This includes the purchase price of the property, any renovations or repairs that you’ve made, and any selling expenses, such as real estate commissions.
Once you have your cost basis, you can subtract it from the net proceeds of the sale to get your capital gain. From there, you’ll apply your marginal tax rate to your capital gain to get your tax bill.
For example, let’s say that you purchase a fixer-upper for $100,000 and spend $20,000 on renovations. You then sell the property less than a year later for $200,000, and your selling expenses add up to $10,000.
In this scenario, your cost basis would be $130,000 ($100,000 + $20,000 + $10,000), and your capital gain would be $70,000 ($200,000 – $130,000). If you’re in the 25% marginal tax bracket according to your income tax rate, then your short-term capital gains taxes would be $17,500 ($70,000 x 0.25).
Long-Term Capital Gains: The Buy-And-Hold
If you’re in the business of buy-and-hold real estate investing, then your capital gains taxes are going to be a bit different than someone who is flipping properties. When it comes to buy-and-holds, your main concern should be long-term capital gains taxes, as that is what you’ll be subject to if you sell the property after a year of ownership.
To calculate your long-term capital gains taxes on a buy-and-hold, you’ll need to first figure out your cost basis. This includes the purchase price of the property, any renovations or repairs that you’ve made, and any selling expenses, such as real estate commissions.
Once you have your cost basis, you can subtract it from the net proceeds of the sale to get your capital gain. From there, you’ll apply the long-term capital gains tax rate to your capital gain to get your tax bill.
For example, let’s say that you purchase a rental property for $100,000 and spend $20,000 on renovations. You then hold on to the property for 15 years before selling it for $200,000, and your selling expenses come to $10,000.
In this scenario, your cost basis would be $130,000 ($100,000 + $20,000 + $10,000), and your capital gain would be $70,000 ($200,000 – $130,000).
If you’re filing as a single individual and you earned less than $459,750 in the year that you sold your real estate investment property, then you’ll only owe 15% on your capital gains (as of 2022). That means that you would owe $10,500 in long-term capital gains taxes on your $70,000 capital gains ($70,000 x 0.15).
However, keep in mind that the capital gains tax rate can change in the future. If you buy a property today and plan to sell it in 10 years’ time, don’t bank on the long-term capital gains tax rate staying the same.
Finally, it’s important to note that any rental income you earn from a rental property is taxed as ordinary income for the year that you earned it – and as such does not affect how your capital gains are taxed once you sell the property.
How To Reduce Capital Gains Taxes On Your Rental Property
Even if you save some money on taxes as a result of your rental property being a long-term investment (rather than a short-term one), you will still owe some taxes when you eventually sell it. Fortunately, there are a few ways to reduce or even eliminate the amount of capital gains taxes you’ll owe.
The following are some of the strategies that you can apply to help lower your capital gains taxes on the sale of your rental property.
Turn Your Investment Property Into Your Primary Residence
If you’ve been living in your rental property for at least two of the past five years, then you might be able to take advantage of the owner-occupied capital gains tax exclusion.
When you sell a property that you’ve been living in as your primary residence, you can exclude up to $250,000 of the capital gains from your taxes if you’re single and up to $500,000 if you’re married and filing jointly.
This means that once everything has been factored into the equation, you may not owe anything on the sale of your property. As such, it might be worth it to turn your investment property into your primary residence for at least a couple of years.
Offset Gains With Losses Through Tax-Loss Harvesting
Another way to reduce or eliminate the taxes you’ll owe on your rental property is to offset your capital gains with losses from other investments. This is often referred to as “tax-loss harvesting.”
For example, let’s say that you sell your rental property for $200,000 and end up with a capital gain of $50,000. However, let’s also say that you have stock investments that have lost $30,000 over the course of the year. In this case, you can use the $30,000 in losses to offset your $50,000 capital gain, which would leave you with a net capital gain of just $20,000.
As such, you would only be taxed on the $20,000, which would significantly lower the amount of taxes you’ll owe on the sale of your rental property. This strategy can be especially effective if you have a lot of investments and can find losses to offset your gains. Of course, this strategy only works if you have any losses. Ideally, you won’t have any losses, which means you won’t’ be able to use this particular strategy.
However, it’s important to note that you can only offset capital gains with capital losses. You can’t offset ordinary income (such as rental income) with capital losses.
Use The Section 1031 Exchange on Your Property Sale
If you’re looking to defer your capital gains taxes on the sale of your rental property, then you might want to consider using the Section 1031 exchange. With a Section 1031 exchange, you can sell your investment property and then use the proceeds to buy another “like-kind” investment property, which means it has to be the same type of property.
For example, if you sell a single-family house, you would be able to use the 1031 exchange to invest your profits into another single-family house. However, you would not be able to use the 1031 exchange if you were to invest in a commercial building since this is not a like-kind property.
As long as you follow the rules and guidelines, you can defer paying any taxes on the sale of your property until you eventually sell the replacement property.
This can be an effective way to defer your capital gains taxes indefinitely. However, it’s important to note that you have to find another investment property to buy within a certain period of time, and the replacement property must be of “like-kind.”
Determine The Best Way To Pay Taxes On Your Investment Property
Investing in a rental property can be a great way to earn passive income and build your wealth over time. However, it’s important to be aware of the tax implications of owning and selling rental property. Depending on your situation, you could end up owing a significant amount of money in capital gains taxes.
Fortunately, there are ways to minimize the amount of taxes you’ll owe on your rental property. Consulting a financing expert can help you get a better idea of how much you should expect to pay in taxes once you sell your rental property so that you can plan ahead. They can also help you determine which strategy will work best for you based on your individual circumstances.