Capital Gains Tax On Rental Property Vs Primary Residence
The IRS allows $250,000 of tax-free profit on a primary residence. What this means, in a simplified sense, is if you bought your primary residence for $300,000 in 2010, lived in it for 8 years, and then sold it in 2018 for $550,000, you wouldnt have to pay any capital gains tax. This amount is doubled if you are married.
For capital gains on rental property, however, the amount of tax you have to pay depends on your personal tax bracket . There is no allowance for investment properties meaning tax must be paid on all profits made after the sale of the investment property.
Another thing that should be taken into consideration is the favorable nature of long-term capital gains taxes compared to short-term capital gains. For an asset to qualify for the long-term gains rate, you will need to have held it for longer than 12 months.
How Long Do I Have To Live In A Rental Property To Avoid Capital Gains Tax
If you like your rental property enough to live in it, you could convert it to a primary residence to avoid capital gains tax. There are some rules, however, that the IRS enforces. You have to own the home for at least five years. And you have to live in it for at least two out of five years before you sell it.
Heres The Best Way To Sell A Rental Property
What ways are there to avoid paying taxes when selling a rental property?
Real estate can be an incredibly important and profitable investment. However, no matter what your top-line profit appears to be, it is only really as profitable as what you get to keep after taxes. If you arent prepared, you could be getting a surprise tax bill from hundreds of thousands of dollars from the IRS. Then pay more than 18% in penalties on that money until you pay them off. You could find you are giving up 25% to 40% or more of what you made. After all of that work and time, you want to make sure you are making more than you could have in a CD or low yield savings account.
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How Much Is Capital Gains Tax In Real Estate
Calculating capital gains tax in real estate can be complex. The tax rate depends on several factors:
- how long youve owned the house
- if the house was your primary residence, a secondary residence or an investment property
Note: The tax is only assessed on the profit itself. If you purchased a house five years ago for $150,000 and sold it today for $225,000, your profit would be $75,000. You would need to report the home sale and potentially pay a capital gains tax on the $75,000 profit.
For the 2022 tax year, for example, if your taxable income is between $41,676 $459,750 as a single filer, and $83,351 $517,200 for married filing jointly, you would pay 15 percent on the $75,000 profit, or $11,250.
However, the IRS gives home sellers multiple ways to avoid or reduce their capital gains taxes, primarily if the property theyre selling is a primary residence. You can exempt a certain amount of the profit up to $250,000 or $500,000, depending on your filing status from the tax, if you meet certain conditions. Details on this below.
What Happens To Depreciation When Selling A Rental Property
When you sell a rental property, you may be liable for capital gains tax, but you might also have to consider additional fees in the form of depreciation recapture. If youve claimed deductible expenses while you owned the property, you will be liable to pay a 25% federal recapture tax on the depreciation value. This means that if you purchased a property for $300,000 and it sold for $500,000, and you claimed $100,000 in depreciation deductions during your ownership, you would be liable for 25% recapture tax on the $100,000 as well as capital gains tax on the $200,000 profit.
To avoid paying depreciation recapture taxes and capital gains, property investors often take advantage of exchange opportunities and invest profits into another rental property. A real estate 1031 exchange enables investors to continue adding to their portfolio without paying tax on every acquisition.
If youre toying with the idea of selling your rental property, its advisable to ensure you understand exactly what kinds of fees youll be liable for in terms of taxes that can be applied to rental properties. If you want to sell and buy another property, its wise to research the terms of the 1031 real estate exchange, as this enables you to save on capital gains and depreciation expenses. To benefit from this strategy, youll need to identify suitable properties within 45 days of selling your property and complete the purchase within 180 days.
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How To Avoid Paying Capital Gains Tax On Rental Property
Every real estate investor wants to make as much as possible from buying, selling, and renting properties. If you sell a rental property, you stand to lose a substantial amount of money by paying capital gains tax, especially if youre in the high earner tax bracket. You could be hit with a tax bill that could put a 20% dent in your profits.
For those looking to reduce the tax burden and sell rental properties without paying tax, there are methods you can employ to avoid paying capital gains tax when you sell your property. There are 3 main options:
1. 1031 Real Estate Exchange
Before you consider a 1031 real estate exchange for your rental property, its crucial to understand the qualifying criteria and stipulations. This type of exchange can only be used under certain circumstances, and there are rules governing its use. These are outlined below:
Properties involved in a 1031 real estate exchange must be used for investment or business purposes only.
The new property must be classified as of like kind. An approved, independent intermediary must be appointed. You cannot act as an intermediary for yourself.
Once your property is sold, you have 45 days to identify new properties and the exchange must be completed within 180 days.
Any funds that are left over from the sale of your property and not used to fund a new purchase are liable for taxation, so its best to search for a property of equal or higher value.
2. Offsetting property gains with losses
Depreciation And Recapture Tax
When you own residential investment property, the IRS allows you to depreciate the value of the property over a period of 27.5 years.
That means if you paid a total of $115,000 for a single-family rental home and the land value was $10,000, your annual depreciation expense would be $3,818 or 3.636% of the property value each year:
- $115,000 total purchase price $10,000 land value = $105,000 cost basis to depreciate
- $105,000 / 27.5 years = $3,818 annual depreciation expense or
- $105,000 x 3.636% = $3,818 annual depreciation expense
If the annual net income from your rental property was $4,500 you could offset that rental income with your $3,818 depreciation expense. Expensing depreciation would reduce the taxable net income from your rental property to just $682. Thats why depreciation expense is one of the biggest benefits of owning income-producing real estate.
However, when you sell your rental property, the IRS wants the depreciation expense that you benefited from returned to them. They do this by collecting a depreciation recapture tax. Recaptured depreciation is treated as normal income, so if you are in the 24% tax bracket, you would owe $916 in depreciation recapture tax for each full year of depreciation:
- $3,818 annual depreciation expense x 24% tax rate = $916
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Rental Property Tax Deductions
There are a number of rental property tax deductions that can be taken advantage of by landlords in order to reduce their overall tax liability. These deductions can include things like the cost of repairs and maintenance, property taxes, and insurance premiums. By taking advantage of these deductions, landlords can save a significant amount of money each year on their taxes.
Renting out your home may be a great way to make some money, and it may even provide some tax benefits. You can reduce your IRS tax bill each year by taking certain rental property tax deductions. These write-offs can be more valuable in high tax brackets. If you purchase a fixer-upper and spend time refinishing it, depreciation cannot be claimed right away. Although you are not required to pay rent during that time, you may deduct the costs of managing and maintaining your rental property. In the year the rental property pays for their insurance, they can deduct the cost of the premiums. The cost of purchasing or leasing office space in your home or commercial space is deductible in some cases.
Avoiding A Capital Gains Tax On Your Primary Residence
You can sell your primary residence and avoid paying capital gains taxes on the first $250,000 of your profits if your tax-filing status is single, and up to $500,000 if married filing jointly. The exemption is only available once every two years. But it can in effect render the capital gains tax moot.
Lets say a single filer bought a home for $250,000, lived in it, and sold it for $400,000 three years later. Their profit is $150,000. But thats exempt from any capital gains tax, because its under the $250,000 threshold allowed for gains.
Of course, there are conditions. To qualify the property as your primary residence, the IRS requires that you prove that it was your main home where you lived most of the time. Youll need to show that:
- You owned the home for at least two years.
- You lived in the property as the primary residence for at least two out of the five years immediately preceding the sale.
However, there is wiggle room in how the rules are interpreted. You dont have to show you lived in the home the entire time you owned it or even consecutively for two years. You could, for example, purchase the house, live in it for 12 months, rent it out for a few years and then move in to establish primary residence for another 12 months. As long as you lived in the property as your primary residence for a total of 24 months within the five years before the homes sale, you can qualify for the capital gains tax exemption.
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Tax Deductions On Rental Properties
Own a rental property? Youre in luck: The Tax Cuts and Jobs Act made several changes for rental property owners that portend a more profitable enterprise than it used to be.
For rental property owners, will generally benefit you, says Thomas Castelli, a New York Citybased certified public accountant and tax strategist with the Real Estate CPA, a firm focusing on real estate tax.
How exactly the federal tax changes apply to individual property owners can vary, so Castelli recommends seeking out a tax professional well-versed in real estate to help sort things out. But heres a general overview of some of the new tax rules that will most likely affect rental real estate ownersincluding me.
Sellthe Company Not The Real Estate
As with all of these potential tax saving ideas, be sure to talk to your own accountant and tax expert to assess the real benefits for you in your unique situation. Some may find that if they hold properties in an LLC or other corporate entity that they can sell shares in that business and pay less in taxes than just selling the underlying asset.
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What Is Depreciation Recapture And How Is It Calculated
The second tax that we mentioned above is depreciation recapture. As an investor, you probably know that you can depreciate your residential investment property over 27.5 years and write off the depreciated amount as a tax-deductible expense each year. However, when you sell the property, the IRS will reclaim some of this depreciated money in the form of depreciation recapture.
Depreciation recapture works by allowing the IRS to tax the total depreciated amount as well as the capital gains amount. Essentially, the amount deducted over time through depreciation is treated as capital gains which are taxed at a specific depreciation recapture rate when the property is sold.
In 2019, depreciation recapture on gains related to the sale of the property was capped at a maximum of 25%.
For example, you buy a property for $275,000 which allows you to deduct $10,000 a year. You hold the property for 10 years, and then sell it for $375,000.
You would pay long-term capital gains tax on the $100,000 capital gains of up to 20%. And you would also pay depreciation recapture tax on the $100,000 that you depreciated over the 10 years up to 25%.
Itâs worth noting that the IRS will assume you claimed all the allowable depreciation each year and will tax you on the full amount even if you did not claim the full allowable depreciation expense.
How Is Depreciation Taxed On Sale Of Rental Property
Because depreciation expenses lower your cost basis in the property, they ultimately determine your gain or loss when you sell. If you hold the property for at least a year and sell it for a profit, youll pay long-term capital gains taxes. Depending on your income level, the tax rate is 0%, 15%, or 20% for 2019.
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The Importance Of Keeping Excellent Records
As with everything, its incredibly important that you keep detailed records of your finances across your investment portfolio. This goes for more than just the single investment asset that you are selling. Keeping good records may actually help reduce the capital gains tax on your rental property. For example, offsetting through losses which we covered above.
When you do sell an investment property you will want to track your capital gains and safely store your historical rental data for future tax purposes and better oversight of even if you delay paying through a 1031.
The best way to show that youve sold your property in the Landlord Studio system is to archive it. This allows you to retain and freely access all your propertys historical data but shows you are no longer renting it out. You can do this by navigating to the property and then select edit property. Scroll to the bottom and under the option Archive Property select yes. Ive attached a help article with screenshots.
You can also track the capital gains on rental property through the Landlord Studio software using the valuation feature paired with our net worth report. The valuation allows you to enter the property purchase price and its current valuation. Then you can run a net worth report for one or all of your properties to gain a clear oversight into your portfolios current net worth or at the sale of investment property to calculate capital gains for tax purposes.
How To Make The Tax Act Work For You
The tax act has been better than expected for rental property owners, Han says. Its a great opportunity for real estate investors.
Good record-keeping is essential for rental owners, and Han recommends property owners keep sales closing disclosures, purchase closing disclosures, refinancing documents, and receipts for anything to do with the home for at least three years.
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A Quick Guide To Capital Gains Taxes On Rental Properties
Owning a rental property is an excellent investment for a couple of reasons. First, it can help generate steady, passive investment income through rent. Second, it can generate a large sum of money when it appreciates in market value.
Unfortunately, owning a rental property can significantly impact your tax bill through property taxes and capital gains taxes when you go to sell the rental property.
Heres a quick guide to help you understand capital gains taxes and how theyre applied toward the sale of investment properties.
Tax Evasions Vs Tax Avoidance When Selling A Rental Property
Evasion and avoidance are two very differentthings.
Tax evasion is very illegal. You cant getaway with anything else if life and business, but not tax evasion. Sooner orlater they will get you.
There are many complex strategies that asset protection firms will try to sell you to evade taxes. Often they can soak up more of your profits than the taxes, and you can still get caught. Its generally not worth it.
Fortunately, legal tax minimization and avoidance are perfectly legal. It can be far simpler. It is even expected by taxing authorities and lawmakers. They design these taxes with these exceptions so that you dont have to pay too much. They expect you to use them. If you dont you are just making supersized donations to organizations that probably dont need your money.
So, dont evade. Do avoid.
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Whats The Tax Bite When You Ownor Sella Rental Property
Natalya Yashina is a CPA, DASM with over 12 years of experience in accounting including public accounting, financial reporting, and accounting policies. She is a member of the Virginia CPA Society Accounting and Advisory Committee and serves on the Board of Directors for the Virginia CPA Society Educational Foundation.She is the founder and CEO of Capital Accounting Advisory, LLC, an accounting advisory firm that offers technical accounting, project management, and training services and solutions.
Whether you already own a rental property or are thinking about buying your first investment, its essential to understand how real estate taxes work. After all, taxes can mean the difference between earning a profit and losing money on a rental property. In general, rental property owners need to be aware of two sets of taxes: those that relate to your rental income and those that relate to the eventual sale of your property.