How to Prevent a Tax Hit When Selling a Rental Property

Original Article Written By: Alicia Tuovila can be found here.

Investing in rental properties can supply investors with steady revenue streams that cover the mortgage while supplying some extra profits each month; when such properties are ultimately sold, investors stand to enjoy substantial windfalls. But these selling events can trigger significant long-term capital gains tax liabilities.

Key takeaways

• Selling rental properties can earn investors immense profits, but may result in significant capital gains tax burdens.
• The capital gains tax rate is 15% if you’re married filing jointly with taxable income between $80,000 and $496,600.
• There are various methods of reducing capital gains tax, including tax-loss harvesting, using Section 1031 of the tax code, and converting your rental property into your primary place of residence.

For a married couple filing jointly with a taxable income of $280,000 and capital gains of $100,000, taxes on the profits from the sale of a rental property would amount to $15,000. Fortunately, there are ways of minimizing this capital gains tax bite. This article explains three of the most effective methods.

Offset Gains with Losses

• What It Is: Tax-loss harvesting
• Who It’s For: Anyone with capital losses in a given tax year
• What You Get: The ability to subtract those losses from the capital gains realized from a rental property sale

Tax-loss harvesting describes the process of reducing tax exposure when selling a rental property by pairing the gains from the sale with the loss from another investment. This can be a tax planning strategy if an investor is holding an investment that has lost value (an unrealized loss) and decides to sell the asset at a loss in the same year as the gain on rental property sale (a realized loss). Although this tax-minimizing tactic is primarily used to offset gains from stock investments, more and more folks are applying it to rental real estate property sales.

For example, assume an investor made $50,000 from the sale of a rental apartment in the current year. She also has an unrealized loss of $75,000 in the stock market. She can choose to sell off a portion of her stocks to realize a $50,000 loss in order to fully offset the $50,000 in capital gains.

Take Advantage of Section 1031 of the Tax Code

• What It Is: IRS Section 1031 “like-kind” exchange
• Who It’s For: Anyone able to reinvest the proceeds of rental property sales in new real estate
• What You Get: The ability to defer some or all taxes on the capital gain

Real estate investors can defer paying capital gains taxes using Section 1031 of the tax code, which lets them sell a rental property while purchasing a “like-kind” property, and pay taxes only after the exchange is made. Legally speaking, the term “like-kind” is broadly defined. An investor need not swap out one condo for another or trade one business for another. As long as both properties in question are income-generating rental units, they’re fair game. 

But timing is key with this method, as investors have just 45 days from the date of a property sale to identify potential replacement properties, which they must formally close on within 180 days. And if a tax return is due (with extensions) before that 180-day period, investors must close even sooner. Those who miss the deadline must pay full capital gains taxes on the sale of the original rental property. 

Turn Your Rental Property into Your Primary Residence

• What It Is: Conversion of rental property into a primary residence
• Who It’s For: Anyone able to convert a rental property into their primary residence
• What You Get: The ability to exclude as much as $500,000 in capital gains from taxes

Selling a home you live in is more tax beneficial than unloading a rental property for a profit. IRS Section 121 allows people to exclude up to $250,000 of the profits from the sale of their primary residence if they’re single and up to $500,000 if they’re married filing jointly. To qualify, investors must own their homes for at least five years and must have lived in them for at least two of those five years. The years as a personal residence do not have to be consecutive. For this reason, some investors choose to convert rental properties into their primary residences.

The deduction amount depends on how long the property was used as a rental versus its use as a primary residence. Additionally, a taxpayer may not exclude the portion of the gain that was previously attributable to a depreciation deduction. This is known as depreciation recapture, specific to rental properties, and the amount previously taken as a depreciation deduction is taxed at a recapture rate of 25%.

The Bottom Line

Capital gains taxes can take a sizable chunk of profits from your rental property sales, to the tune of 15% or 20% of your take. Fortunately, capital gains tax avoidance and deferment strategies can help ease that burden. As always, consult a tax professional for advice specific to your own rental-property situation.