How to Offset Rental Property Taxes When Selling

Sep 19, 2020 | Sell Real Estate

We all know that investing in rental properties can provide an excellent revenue stream that goes into your mortgage, savings, or other investments.

But when it comes to selling a rental property, capital gains taxes can hit hard if you’re not careful.

Here is an overview of how rental properties are taxed when sold followed by successful methods that you can use to reduce the heavy tax blow that would otherwise leave you reeling.

What are Capital Gains?

Put simply, a capital gain is when you sell an asset for more than you bought it for.

If you bought an apartment for $200,000 and sold it for $225,000, then you made a capital gain of $25,000. And viewed as a form of income, your capital gain is subject to taxes.

It is important to note that related expenses such as acquiring, maintaining, and selling the rental property are included in calculating capital gain.

This means that a related expense, like a sales commission, will be subtracted from your capital gain value.

Capital Gains Tax Rates

Your capital gains tax rate is based on your income and whether you have owned the asset for a year or more. 

If you have owned the rental property for over a year, then you will fall into one of two long-term capital gains tax brackets: 

  • Married couples filing jointly with a combined income between $78,751 and $488,850 are taxed at 15%.
  • Single property owners with an annual income between $39,376 and $434,550 are also taxed at 15% 
  • Married couples filing jointly with a combined income over $488,850 are taxed at 20%.
  • Single property owners with an annual income over $434,550 are also taxed at 20%

If you have owned the rental property for less than a year, then short-term tax rates will be applied. These will match your income tax rate bracket and can be a lot steeper for anyone selling a rental property. For example: 

A single property owner with an annual income of $420,000 would be taxed at 35% for their short-term capital gains versus 15% for their long term.

Now that you can see how these taxes are applied, let’s look at three common methods for reducing the blow that property owners can be hit by.

Converting Your Rental to Your Primary Residence

Selling the home in which you live in is better from a tax perspective than selling a rental property for a profit.

According to IRS Section 121, in order for the property to be sold as your primary residence, you will need to have owned the property for at least five years and have lived in the property for at least two. 

The amount deducted depends on the ratio of time the property was used as a rental versus the time you spent living in the property.

So, if you have owned the property for ten years, renting it for six and living in it for four years, when you sell you will be able to deduct 40% from the taxable capital gains

This is because for 4 out of 10 years, you were using it as your primary residence, not as an investment property.

For a capital gain of $100,000, you would subtract 40% ($40,000), leaving only $60,000 to be taxed. This option allows you to exclude up to $250,000 worth of capital gains if you are single, and $500,000 for married couples. 

Offsetting Gains with Losses

Offsetting your capital gains with any capital losses is an effective way of limiting your overall tax exposure when selling a rental property.

You can pair the capital gains you generated from selling your rental property with any capital losses incurred from the sale of different asset. 

Since the offset amount is based on your capital loss, there is essentially no limit to the amount that you can offset. For example: 

If you made $75,000 in capital gains from the sale of a rental property but lost $30,000 on a separate investment, you can use that loss to offset your gain.

With this, only $45,000 would be exposed to capital gains taxes.

You cannot, however, use a sale as a loss for offsetting your gains if, after making the loss, you purchase the same or similar security within 30 days of the losing transaction

Use Section 1031 of the Tax Code

The 1031 like-kind exchange allows for rental property owners to “swap” one investment property for another.

This simply means that any capital gains from the sale of your investment property will be deferred until you sell the following property for cash. 

This works out better than paying the full amount of taxes on the sale of your property before purchasing a different investment property.

After the initial property has been sold, you have 45 days to find the “swap” property you wish to purchase.

After that point, you have 180 days to close on the new property. Any leftover cash will be subject to partial capital gains taxes.

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