If you own one or more rental properties and you’re considering selling this year, it’s important to think about the impact capital gains tax on rental property could have on your profit — and on your future goals for that money.
Planning ahead is key to minimizing the hit to your bottom line. So read on for some capital gains tax basics and a few strategies that can help rental property owners lower the tax burden when they decide to sell.
Capital Gains in Real Estate
When you invest in real estate, the expectation (or hope, at least) is usually that when you sell it, you’ll make a nice profit on the deal. It’s one reason so many people have been investing in single-family rental homes in recent years.
You may already have a plan for how you’ll use that profit — to make another investment, for example, or to put toward your retirement. But if the value of the property has increased substantially during the time you’ve owned it, you should also be prepared to hand over some of your gains to the IRS to cover the capital gains tax.
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What Is a Capital Gain?
When you determine how much a house is worth, find a buyer, and sell a capital asset for more than you paid for it, the increase in value is referred to as a capital gain.
Capital gains taxes are the taxes you pay on the profit you made because of that increase in value. The tax isn’t applied while you own the asset — in this case a rental property. It hits only when you profit from the sale.
Short-Term vs. Long-Term Capital Gains
The length of time you owned the property before selling it determines whether your profit is a short-term or long-term capital gain. This distinction can make a significant difference in how, and how much, your gains are taxed.
• Short-term capital gains: If you sell the property after owning it for a year or less, the profit is considered a short-term capital gain, and you’ll be taxed at your ordinary income tax rate for the year you made the sale. Tax rates are always subject to change, but the maximum you could pay for short-term capital gains on a rental property in 2024 is 37%.
• Long-term capital gains: If you sell after holding the property for more than a year, the profit is considered a long-term capital gain, which makes it subject to preferential capital gains tax rates. Long-term capital gains tax rates are set at 0%, 15%, and 20%, based on your filing status and income.
How Capital Gains Tax Works on Rental Properties
If you’ve ever sold a home, you’re probably familiar with the “home sale exclusion” that eligible home sellers can use to avoid or reduce the capital gains tax on the sale of their primary residence.
Unfortunately, this exclusion typically doesn’t apply to a property used as a rental. (Though there may be an exception if you lived in the property during part of the time you owned it and rented it part of the time.)
Factors Affecting the Capital Gains Tax You May Pay
Without the home sale exclusion, the primary factors that will go into deciding how much you ultimately could be taxed on your gains include:
• How long have you owned the property?
• How much did you pay for the property?
• How much did you spend on improvements to the property?
• How much did you claim in depreciation?
• How much did you sell the property for?
• What was your filing status and taxable income in the year you made the sale?
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Calculating Capital Gains on Rental Property Sales
These steps can help you estimate the gain on the sale of a rental property:
1. Start by determining your cost basis (or adjusted cost basis if you made major improvements). This is the price you originally paid for the property, plus money you spent on major improvements (such as additions and upgrades), minus the amount you claimed for depreciation over the years and/or casualty and theft losses.
2. Next, calculate the capital gain. To do this, subtract your adjusted cost basis from the net proceeds of the sale. (Net proceeds is the amount the seller walks away with after all the closing costs are paid and any home loan balance is paid off.)
Strategies to Minimize Capital Gains Tax on Sale of Rental Property
There are several strategies that can help sellers avoid paying capital gains tax on real estate, either by legally deferring or minimizing their gains.
1031 Exchange
A 1031 exchange is an effective but complicated strategy that allows the owner of an investment property to defer paying capital gains taxes if the sale’s proceeds are reinvested into a replacement or “like-kind” property.
The IRS has several rules regarding the type of property that can be used in the exchange, the timeline, and other details, so you may want to consult with a tax professional if this strategy appeals to you.
Tax-Loss Harvesting
With tax-loss harvesting, you can sell long-term positions in your investment portfolio that have produced capital losses, replace them with similar (but not identical) investments, and then use the loss to offset the gains from the sale of your rental property.
If your losses exceed your gains, you can even use the excess to offset up to $3,000 of ordinary income that year, with any remaining losses carried forward to future years. But again, you’ll likely need some professional help to make sure you’re getting the most out of your investments and that you’re following IRS rules.
Installment Payments
If you prefer to spread out your capital gains tax liability over a period of several years, you may want to look at the benefits of receiving installment payments from the buyer instead of a lump sum. With this method, you would pay capital gains tax only on the portion of the gain you receive each year until the property is paid off.
Convert the Rental Property to Your Primary Residence
If you move into the rental property and make it your primary residence before the sale, you may be able to use the home sale exclusion to reduce your capital gains.
Of course there are IRS rules: To qualify, you must own and occupy the property as a principal residence for two of the five years immediately before the sale. But the ownership and occupancy don’t have to be concurrent, so if you’ve lived in the property as your primary residence for at least 24 of the last 60 months, the gains may qualify for the tax exemption.
Reporting Capital Gains on Rental Properties
The IRS has specific rules for reporting the capital gains on a rental property.
You can start by making sure you get a copy of Form 1099-S. Typically, the person who closes the transaction (real estate attorney, lender, real estate broker title company, etc.) is required to file this form in order to report the sale of a business property. Copies go to the seller and the IRS.
You’ll use Form 1099-S along with other records and receipts to report the capital gains from the sale on your tax return. It’s important to have the original closing documents from your purchase, the real estate purchase contract and closing documents from the sale, receipts related to major improvements, records of any depreciation claimed, and any other relevant paperwork related to the property. This way you (or your tax professional) can more accurately complete the appropriate tax forms and schedules when it’s time to file your tax return.
Filling out these forms can be challenging, especially if it’s your first time selling a rental property and dealing with capital gains. You may want to tap a tax attorney or other professional for the job to ensure that you’re fully compliant with IRS rules.
State-Specific Capital Gains Taxes
Depending on where you reside, you also may have to pay taxes on your capital gains to your state. Most states have a capital gains tax rate between 2.9% and 13.3%, although some states (Alaska, Florida, New Hampshire, Nevada, South Dakota, Tennessee, Texas, and Wyoming) don’t charge any capital gains tax.
Impact of Capital Gains on Investment Strategy
Smart planning can help investors manage and mitigate the impact of capital gains. Some things to consider include:
• Timing: If you can put off selling an asset until you’ve held it for at least a year, you can qualify for the lower long-term capital gains tax rate. Delaying also may make sense if you decide to wait until you have investment losses that can offset the profit from the sale of your rental property. Or you could wait for a year when your income is lower so that you’re taxed at a lower rate.
• Reinvestment opportunities: Reinvesting the profit from your sale into another investment could open up new opportunities to grow your money — and possibly reduce or defer your tax liability (if, for example, you choose to do a 1031 exchange). A financial advisor can help you figure out your next move and what might be a good fit for your goals.
• Think holistically: How does selling or not selling the rental property fit into your overall investment plan? It might be better to sell for a profit now and pay the taxes than to wait and end up losing money on the sale.
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Common Mistakes to Avoid with Capital Gains Taxes
Ultimately, it’s your responsibility as the seller to make sure your capital gains tax is accurately calculated and paid on time. Getting the amount wrong or failing to pay could result in IRS penalties. Some common mistakes to avoid include:
• Failing to report capital gains. It’s important to report all capital gains, whether you think you’ll owe taxes on the amount or not.
• Miscalculating the cost basis. This number is key to determining your gains (or losses) and, therefore, what you’ll owe the IRS.
• Record keeping errors. Keeping good records can make calculating your capital gains tax easier, and you may need to provide those records and receipts if the IRS asks for documentation.
Working with Tax Professionals
You may have noticed that the word “professional” comes up repeatedly in this guide. That’s because selling a rental property, and the variables that can go into calculating and reporting the gain on your tax return, will be a little different for every seller. There’s no one-size-fits-all process for DIYers to replicate.
And let’s face it, it can be pretty darn difficult to decode the tax code if it isn’t your line of work. If your goal is to legally maximize your tax breaks, it can be helpful to seek out a tax attorney or an experienced tax professional who specializes in real estate issues.
The Takeaway
Understanding how to avoid capital gains on the sale of a rental property, and doing some proactive planning, could make a big difference to your bottom line. And the more money you can keep from the sale, the more you’ll have to put toward your other financial goals — whether they’re personal, for your business, or both.
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FAQ
What are short-term capital gains?
Short-term capital gains are profits from the sale of an asset held for one year or less. (Long-term gains, as you might imagine, are the profits from an asset held longer than a year.)
Can I avoid paying capital gains tax on the sale of a home?
If the home is your primary residence, the IRS allows you to exclude a portion of the capital gain from its sale (up to $250,000, or $500,000 if married filing jointly).
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