Investing in rental real estate can provide investors with a constant income stream that covers the mortgage and, at the same time, provides additional income each month; when these properties are finally sold, investors can enjoy some big, unexpected gains. But these selling events can trigger vital long-term capital gains tax obligations.
Case in point: for 2020, the tax rate is 15% if you are married and file a joint tax return between $78,750 and $488,850. If your income is $488,851 or more, your capital gains rate increases to 20%.
For a married couple with a taxable income of $280,000 and capital gains of $100,000, the tax on gains from rental property sales would be $15,000. Fortunately, there are ways to minimize this capital gains tax. Below is a list of methods that explains the most effective methods.
Offset profit with loss
What is it: tax-loss harvesting
Who it is intended for: anyone who has suffered a loss of capital during a given financial year.
What you get: the ability to deduct these losses from capital gains from selling a rental property.
Tax-loss harvesting explains the process of reducing tax exposure when selling a rental property by combining the proceeds of the sale with the loss of another investment. This can be a good tax preparation strategy if an investor has an investment that has an unrealized loss and decides to sell the business at a loss in the same year as the gain from the rental property's sale (an unrealized loss). Although this tax reduction tactic is primarily used to offset capital gains, more and more people apply it to the sale of rental properties.
For example, suppose an investor earned $ 50,000 from the sale of a rented apartment this year. He also has an unrealized loss of $ 75,000 on the stock market. He can choose to sell some of his shares for a loss of $ 50,000 to offset the $ 50,000 in capital gains fully.
Section 1031 of the tax code.
What is it: "like-kind" exchange of the IRS section 1031
Who is it for? Anyone who is able to reinvest the proceeds from the sale of rental properties into new properties.
What you get: the capability to defer some or all of your capital gains taxes.
Real estate investors can defer the payment of capital gains tax by using Section 1031 of the Tax Code, which allows them to sell a rental property while buying a "similar" property and not pay the taxes. Taxes are paid only after the exchange is made. Legally, the term "like-mind" is defined broadly. An investor does not have to trade one business for another or trade one condominium for another. As long as both properties income-generating rental units, they are fair game.
With this method, timing is key. Investors have only forty-five days from the date the property is sold to identify possible replacement properties, which must be formally closed within 180 days. And if a tax return (with extensions) is due before these 180 days, investors must close even earlier. Those who do not meet the deadline must pay the capital gains tax on the original rental property's sale.
Make your rental your main residence
What is it: the transformation of a rental property into the main residence
Who is it for: anyone can transform a rental property into the main residence.
What you get: the ability to exclude capital gains up to $ 500,000 in taxes
Selling a house in which you live is more tax-efficient than forgoing a rental property. IRS Section 121 allows individuals to exclude proceeds of up to $ 250,000 from the sale of their primary residence if they are single and up to $ 500,000 if married, filing a return jointly. To be eligible, investors must have owned their home for at least five years and have lived there for at least 2-5 of those years. The years as a personal residence does not have to be consecutive, so some investors choose to make rental properties their primary residence.
The deduction depends on the length of time the property has been used for rental compared to its use as a primary residence. Also, a taxpayer cannot exclude the portion of the previously allocated profit to capital cost allowance. This is called depreciation recapture, specific to rental properties, and the amount previously considered capital cost allowance is taxed at a 25% recapture rate.
The Bottom Line
Capital gains tax can generate a significant portion of the proceeds from the sale of your rental property, i.e., 15% or 20% of your take. Fortunately, capital gains tax deferral and tax avoidance strategies can make this task easier. As always, consult a tax professional for specific advice on the condition of your rental property.
Summary
Selling rental properties can generate significant profits for investors and create a significant tax burden on capital gains.
The capital gains tax rate is 15% if you are married, filing a joint tax return with taxable income mid $78,750 and $488,850.
There are several methods of reducing capital gains tax, including tax-loss harvesting, using Section 1031 of the Tax Code, and making the rented property the primary residence place.
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