When an investor sells a long-term rental property at a profit, they’ll enjoy a nice windfall of cash. However, they will also be liable to pay any capital gains taxes on real estate sold. So, what happens when tax season rolls around, and capital gains taxes take half of your investment return? This scenario happens to real estate investors all the time. It’s like getting a $10,000 bonus at work and only getting $7,800 after taxes. 

The good news is there are ways for real estate investors to offset capital gains and minimize getting hit with a huge tax bill. To start, let’s jump into the basics. 

What Are Capital Gains?

Capital gains are the profits made from selling an investment, such as stocks, real estate, business, land, etc. When an asset is later sold at a higher price, the difference (the price you sold it at minus the price you paid) is considered a capital gain.  

For example, if you bought a stock 10 years ago for $5,000, and it is now worth $55,000, when you sell the stock, that $50k is considered a capital gain and will be taxed as such.  Basically, capital gains are any investment that produces a monetary return when it’s sold. On the other hand, investors may experience capital losses with their investments, which we’ll explain next.

What is a Capital Loss?

A capital loss occurs when an investment is sold for less than its original purchase price. Capital losses are significant when it comes time to file taxes because they can be subtracted from capital gains. Investors often use capital loss strategies to offset their capital gains taxes, reducing the amount of money owed on taxes. 

What Are Capital Gains Taxes on Real Estate Investments? 

Capital gains from real estate investments are taxed when the asset is sold. Regardless of how much the property realizes or grows over time, investors won’t have to worry about capital gains until they sell. 

These taxes can be imposed on both a state and federal level. Keep in mind that taxes on capital gains only apply to investment properties–not primary residences–as long as the homeowner lives in the home for two years or more. 

Real Estate Capital Gains Tax Rates 

Most states tax capital gains at the same rate as your federal income tax. Some states are super tax-friendly and have no income tax and no capital gains taxes. Other states have no income tax but still tax dividends and interest. Where your rental property is located will play a major factor in how much you’ll be taxed for capital gains at a state level.

How long you own a rental property and your taxable income will determine your capital gains tax rate. Short-term investments held for one year or less are taxed at your ordinary income tax rate. Current tax rates for short-term gains are 10%, 12%, 22%, 24%, 32%, 35%, and 37%. 

Investments held long-term, more than one year, will be taxed at a lower rate. The following are current tax rates for capital gains on long-term real estate investments sold. 

How to Calculate Capital Gains Tax on Real Estate

In order to accurately calculate capital gains taxes on real estate, first subtract the “cost basis” or original purchase price of the house from the “net proceeds” or net profits of the sale. 

Cost basis includes expenses (i.e., closing costs, fees, etc.) at the time of purchase and any major improvements made to the property,  like a new roof, windows, or electrical system, etc. Routine maintenance and superficial repairs/updates (new paint, light fixtures, etc.) don’t count towards your cost basis deduction.

Net Proceeds are the money you, the investor, walk away with after all the closing costs are paid. Any costs accrued during the sale of a property can be deducted from the gross profits. 

For example, Elaine bought an investment property in 2000 for $250,000. In 2020, the property sold for $550,000. Her total capital gain is $300,000 before subtracting expenses and improvement costs. Now let’s assume the following associated expenses:

• $10,000 in closing costs upon purchase of the rental property,
• $10,000 for a roof replacement,
• $25,000 for new plumbing, and
• $50,000 in commissions and fees upon sale of the rental property.

In this scenario, Elaine’s cost basis would be $295,000 ($250,000 + $10,000 + $ $10,000 + $25,000), and her net proceeds would be $500,000 ($550,000 – $50,000). 

Now, deduct Elaine’s cost basis from her net proceeds to determine the total capital gains on the investment property.

(Net Proceeds) – (Cost Basis) = (Total Capital Gain)

$500,000 (Net Proceeds) – $295,000 (Cost Basis) = $205,000 (Total Capital Gain)

The investor will then be responsible for paying a percentage of the total capital gain, depending on their tax rate. In our example, the total capital gain came to $205,000.

Next, let’s use this same example to illustrate how to calculate capital gains taxes when you sell a rental property. 

How Much Tax Do You Pay When You Sell a Rental Property?

Every time an investor sells an investment property, they should know how much to expect to pay in taxes. Using the example above, let’s calculate the capital gains taxes on Elaine’s investment property. 

Elaine is a single-filing taxpayer with an annual income of $100,000. Because she earns more than $47,026 and less than $492,300 per year, Elaine will be taxed on 15 percent of her total capital gain.

• $205,000 x 15% = $30,750 Capital Gains Taxes 
• Total Return on Investment: $174,250

With $30k due in taxes, it is easy to see the impact capital gains taxes can have on your return on investment (ROI). Fortunately, there are several ways to avoid these high taxes when selling your investments. 

How to Avoid Capital Gains Tax on Rental Property?

There are several ways for investors of all types to lower their capital gains tax burden. These include selling investments at a loss, utilizing a 1031 exchange to “swap” rental properties, or converting a rental into a primary residence. Each of these strategies is commonly used to provide tax relief for investors and offset capital gains. 

1. Tax-Loss Harvesting

Tax-loss harvesting is when an investor sells underperforming investments at a loss in order to minimize capital gains taxes. This strategy works best if you’re looking to offload bad investments and turn them into tax deductions. 

Picture this: Last year, you sold an investment property and made a net profit of $100,000. In the same year, you sold some bad stocks at a $75,000 loss. Because you are allowed to subtract capital losses from capital gains, your tax liability would now be $25,000. This is a common strategy used by investors to avoid paying big capital gains taxes. After selling investments at a loss, some investors may choose to reinvest that money.

2. Section 1031 Exchange

The IRS has outlined under section 1031 a “like-kind” exchange of investment properties. This strategy doesn’t reduce capital gains taxes; it just defers some or all of these taxes to a later date. Using a 1031 Exchange, investors may sell a rental property and “swap” it for a similar or “like-kind” property. 

This is a great strategy for investors who want to exit poorly performing real estate markets and enter strong, growing markets. 

3. Max Out Your IRA/401k

Investors who are worried about being crushed by taxes should consider ways to decrease their taxable income. One of the most common ways to do that is by contributing to their retirement accounts. Maxing out an IRA or 401k allows investors to keep their money safe and reduce the amount of their income that can be taxed.

4. Convert Rental Into Primary Residence

There are way more tax benefits when you sell a primary residence than an investment property. That’s why some investors will choose to convert a rental property into their primary residence. While this may not be an option for everyone, it can provide huge tax benefits. 

In order to qualify for primary residence tax exemptions, investors must own the property for at least five years and have lived in it for at least two of those years. When selling a primary residence, single investors may exclude as much as $250,000 of profits. Those who are married and filing jointly can exclude up to $500,000 of profits. Turning a rental property into your primary residence can qualify you for big tax savings and help avoid capital gains taxes.  

5. Sell When Your Income is Low

Another great strategy to reduce the impact of capital gains on your investment property is to time when you sell. If you know you’re heading into some “thin” years or your spouse is planning on quitting their job, that would be a great time to consider selling. Your income will be less, which may put you in a lower tax bracket and lower your capital gains tax responsibility.

6. Donate to Charity / Gift It

Donating an asset to charity not only saves you from capital gains taxes but also provides a tax deduction. The IRS allows investors to deduct the assets’ fair market value, and the charity doesn’t have to pay capital gains taxes either (because it is tax-exempt).

Investors can also choose to gift an appreciating asset to family members. This works well if the family member receiving the gift is in a lower tax bracket because if they decide to sell, they’ll be taxed at a lower rate. Parents looking to reduce capital gains taxes might consider giving away some real estate assets to their kids now rather than later. Keep in mind that this strategy doesn’t work for dependents under the age of 24 (as they have no taxable income).

7. Wait ‘Til You’re Dead

This may sound strange, but keeping your assets until you’re gone is a pretty common estate planning strategy to avoid paying taxes on capital gains. Assuming the asset has appreciated over time, the beneficiaries can take advantage of a “step-up” in cost basis. This “step-up” is to help offset capital gains taxes on inherited assets.

Continue Learning

Learning how to calculate capital gains tax on real estate investment property isn’t as difficult as it sounds. With a basic understanding of how taxes work in real estate, investors can take advantage of money-saving tax strategies to reduce their tax burden and increase overall returns. 

How RealWealth Can Help You

At RealWealth®, we provide investors with the tools and resources they need to learn about passive real estate investing and then simplify the process by connecting them with providers who sell professionally managed turnkey properties in the top markets nationwide. Membership is 100% free, yes, free! Along with education and exclusive investment opportunities, members also have access to our network of trusted pros, including 1031 exchange facilitators and certified public accountants (CPAs) who understand the ins and outs of capital gains tax on real estate and can help you make the most out of your investment properties. If you are ready to build passive income with real estate, join RealWealth today!