Every landlord wishes to have a rental property with a steady income. A steady rental income helps cover mortgages and provides extra profit to improve your living standards. But owning rental properties also comes with its share of challenges, such as high vacancy rates and poor management.
Thankfully, a rental property can appreciate and attract fewer tax fees. If your rental property increases in value over the years and you’re making losses, the best decision is to sell it. Selling the property after appreciation is beneficial as it increases your cash flow.
However, selling can also attract other problems, like paying capital gains tax and reducing the total amount earned from the sale. To avoid such issues, you will want to think strategically about capital gains tax.
But can you avoid paying capital gains tax on a rental property?
Understanding Capital Gains Tax
A capital gain tax is the levy on your profit after selling your rental property. The taxable amount is the difference between the asset buying price (including expenses and other closing costs) and the selling price. The tax for the particular year you sold the property ranges between 0-20% depending on your tax bracket, which changes yearly.
As a landlord, you can pay a long-term capital gains tax if your property is more than one year old. However, if it's a less than a year old property, it will be a short-term capital gains tax.
A long-term capital gains tax is advantageous for the landlord as it is lower than that of a short-term capital gains tax. This is because a short-term capital tax equals ordinary income tax rates ranging between 10- 37% in 2022. But the long-term capital gains tax in 2022 is 0-20%, meaning you will save on costs.
What Triggers You to Pay Capital Gains Tax?
The only thing that can trigger you to pay capital gains tax is to avoid the Internal Revenue Service (IRS). Failure to do so attracts fines and penalties for negligence. It can also attract criminal prosecution if the IRS determines the act was intentional or fraudulent.
If you are selling your rental property, it's best to fill out Form 8949 (Sales and Other Dispositions of Capital Assets). Then you will receive Form 1099-S.
Related Reading: Is Landlord Insurance Tax Deductible?
How Much Is Capital Gains Tax?
The amount you can pay as capital gains tax depends on two main factors. The first factor is how long you have held the asset. For example, if you have kept the rental property for several years, the capital gains tax may be lower than if it's been for a short term. Additionally, the amount of income tax you earn also determines this amount.
Most citizens' net capital gains tax in the USA is 15%. But the single can pay 0% if their taxable income is not more than $41,675. However, this can increase to 15-20% if your taxable income is higher than that. But it can't exceed 37%, which is the short-term capital gains tax range.
Other factors that determine the amount you can pay as capital gains tax include:
Home Sale Exclusion
You can receive a special 211 exclusion on capital gains on your principal residence. If you sell the main residential home that you lived in for more than two years, $250,000 from the total sales may not be taxed. If you're a married couple and file jointly, the exclusion amount increases to $500,000.
The Net Investment Income Tax
You may pay Net Investment Income Tax (NIIT) if you get a high profit from your property. It can increase your capital gains tax by 3.8%. This mostly happens if your Modified Adjusted Gross Income (MAGI) is more than:
- $250,000 if you are a widow(er) with a child or married and filing jointly
- $200,000 if single or a household head
- $125,000 if married and filing separately.
Are There Ways to Avoid Capital Gains Tax?
Yes, there are ways individual landlords can use to avoid paying the capital gains tax. Remember, selling your rental property is not a walk in the park, as you have to figure out the right time to sell it so that you can gain maximum benefit. Moreover, you must be tactful to avoid incurring losses if your rental property fails to attract lucrative income.
You can do that by:
Opting for Tax-Deferred Retirement Plans
One of the easiest ways to avoid paying capital gains tax after selling your rental property is to invest in a retirement plan. You can invest in a 401(K) or an individual retirement account (IRA). Retirement plans enable you to buy and sell property within the retirement account without attracting capital gains tax.
You can save that amount until retirement and withdraw it from your account at a lower tax bracket or for free. But you must follow the stipulated rules to avoid attracting ordinary income tax.
If you invest outside your retirement accounts as a real estate investor and are almost retired, you might wait until you retire before selling. If your retirement income is low, your capital gains tax can be reduced.
Make Your Rental Property Your Primary Residence
Alternatively, you can change your rental property to be your main residential home. Doing this reduces $500,000 from your taxable capital gains. As a single taxpayer, you get $250,000 excluded from your taxable capital gains.
But you must abide by the laws that allow you to make your rental property your primary residence. For example, you must have lived in the home for at least two years out of 5 years of owning the property. Also, you shouldn't be excluding another property from capital gains tax for the next two years.
It's advisable to talk to your tax advisor before taking this move to avoid facing such challenges as depreciation recapture.
Related Reading: What is good cash flow on a rental property
Sell Your Rental Property to Reinvest
Another way to increase your cash flow and avoid paying capital gains tax is by reinvesting in your property. Use the 1031 tax-deferred exchange form to buy another rental property after selling the other one.
According to IRS section 1031, a real estate investor can avoid paying capital gains tax on every property they own. But they must ensure each form is for an individual property and buy another property within 45 days from the original property sale date. Then close the deals within 180 days.
Choose Tax Harvesting
Another way to avoid capital gains tax is tax harvesting. Here, you can sell your rental property at a loss to reduce the capital gains on the other property you sold within the same year. As a real estate investor, doing this helps you balance losses and gains from other investments.
This is a good decision if your first property attracts high capital gains tax and the second one won't. It will help reduce your capital gains within the year, and you will pay less tax.
Work Tactfully with Your Holding Periods
You can also avoid paying more by owning the property for longer. Remember, if you own the rental property for more than two years, it will attract less tax than when it is in your possession for six months. So, be patient and watch the buying dates to avoid messing up. After qualifying for long-term capital gains tax, sell your property and enjoy the returns.
Being Strategic With Your Sale Date
You can also reduce this tax burden by managing the dates you officially possessed the title dead and reporting the capital gain transaction. If you put off the transfer ownership for a year, you’ll have a lower tax burden. If you have no/less active and minimal passive income and sell your rental property, it can help avoid paying minimal capital gain tax.
Are There Any Risks or Considerations in Trying to Avoid Capital Gains Tax?
The IRS code section 1031 doesn't allow capital gains tax avoidance in all circumstances.
- For example, in the U.S., a landlord can’t change their rental property, buy another one in a foreign country, and benefit from tax-deferred exchange status.
- Additionally, changing a personal residence to a rental property can't receive tax-deferred treatment.
- Also, the exchanged property must be related to the business or property.
- You should also identify the new property for reinvestment within 45 days. Ensure you write to the seller within the time for the first transfer.
- Finally, the transfer of ownership of the reinvestment property must happen within 180 days. This can also be by the tax return due date.
- Here are some specific state details around 1031 exchanges - Colorado 1031 rules, California 1031 rules, 1031 rules for other states can be found on our blog page
Other Considerations For Minimizing Capital Gains on Rental Properties
- Partial Exclusion for Mixed-Use Properties: If the rental property was used as both a rental and your primary residence during different periods, you might still qualify for a partial exclusion of capital gains.
- Installment Sales: Utilizing an installment sale can spread the capital gains over several years, potentially reducing the tax burden by keeping you in a lower tax bracket in any single year.
- Opportunity Zones Investment: Investing the gains from the sale of a rental property into a qualified Opportunity Zone fund can defer and potentially reduce capital gains taxes.
- Estate Planning Considerations: Inheriting property often results in a step-up in basis, which can minimize capital gains tax for heirs.
- Charitable Donations: Donating property or proceeds from the sale to a charity can provide tax benefits, including a potential deduction and avoidance of capital gains tax.
- Conversion to Business Use: If the property is converted for use in a business, such as a home office, certain deductions and tax treatments might apply, affecting the capital gains calculation.
- Consultation with a Tax Professional: Always advisable to consult with a tax advisor or accountant for personalized advice, as tax laws and regulations can be complex and change frequently.
Bottom Line
Capital gains tax can lower your return on investment, making you incur losses. It can also discourage real estate investors from investing in various rental properties. That's why a landlord should avoid paying capital gains tax on rental property.
You can avoid paying this tax by using the 1031 deferred exchange or tax harvesting. Alternatively, you can convert your rental property to a primary residence or invest through a retirement account.
Don’t forget to insure your property with Steadily to avoid making losses after investing in real estate. Get your quote today to determine the best coverage for your needs.
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