Selling a rental property can be a financial windfall, but it also comes with a potentially hefty tax bill. Fortunately, there are several strategies to minimize your tax liability. This article explores five key methods to help you keep more of your profits.
Understanding capital gains tax on rental properties
When you sell an asset, including a rental property, for more than its purchase price, the profit is subject to capital gains tax. For example, if you bought a rental property for $300,000 and later sold it for $400,000, you would be taxed on the $100,000 profit.
Short vs. long-term capital gains
Capital gains are classified as either short-term or long-term:
- Short-term capital gains apply when a property is sold within a year of purchase and are taxed as ordinary income, with rates ranging from 10% to 37%.
- Long-term capital gains apply when the property is held for more than a year, with more favorable tax rates of 0%, 15%, or 20%, depending on income level.
To minimize taxes, it is crucial to understand these rates and plan accordingly.
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Strategies to reduce capital gains tax
1. Hold the property for more than a year
Selling a property after at least a year qualifies the profit for lower long-term capital gains tax rates. This simple strategy can significantly reduce your tax burden.
2. Convert the rental property to your primary residence
If you live in the property for at least two years within five years before selling, you may qualify for the primary residence exemption. Under Section 121 of the Internal Revenue Code, individuals can exclude up to $250,000 of capital gains from taxation ($500,000 for married couples filing jointly).
3. Utilize a 1031 exchange
A 1031 exchange, named after Section 1031 of the IRS code, allows investors to defer capital gains taxes by reinvesting proceeds from a sale into a similar investment property. To qualify, you must:
- Identify a replacement property within 45 days.
- Complete the transaction within 180 days.
- Use an intermediary to hold the proceeds.
This strategy is ideal for those who wish to continue investing in real estate while deferring tax payments.
4. Sell when the income is lowest
The capital gains tax rate is determined by one’s total income. Plan to sell if at all possible in a year with lower income amounts so that the sale would fall into a lesser tax bracket. This is especially advantageous for retirees or those suffering temporary income reductions.
5. Offset gains with tax-loss harvesting
Selling underperforming investments at a loss during the same year as the sale of a rental property will offset the taxable capital gains. In the event that there are losses over and above gains, the excess losses may be used to offset up to $3,000 ($1,500 for married individuals filing separately) of ordinary income, with any remaining balance carried forward to subsequent tax years.
Deductions of expenses incurred
Actual expenses incurred on the rental must be deducted from taxable gains, including:
- Mortgage interest
- Property maintenance and repairs
- Real estate commissions
- Legal and advertising fees
- Depreciation expenses
You can even raise your basis, thus lowering the taxable gain by improving the property. Tax Planning Everybody knows tax planning is a complex subject. It helps to have a tax professional on your side to ensure that you are compliant with the IRS rules and savvy in using your tax-saving opportunities.
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Bottom Line: Hold the property for some time (more than a year), make it your primary residence, use a 1031 exchange, sell when the income is low, tax-loss harvest, and deduct expenses, and you can reduce taxes significantly. With proper planning and a professional’s advice, your profits become yours while selling an investment property.
