Property owners buy investment properties with the expectation of generating a steady stream of income each month. When it’s time to sell their rental properties, they can benefit from the proceeds — especially if they’re selling it for more than what they paid for.
However, selling an investment property can be taxing — literally. The Internal Revenue Service (IRS) considers your property as a business investment and will want a chunk of your earnings. Fortunately, there are ways to reduce the taxes you have to pay when selling a rental property.
What Taxes Do You Need to Pay When Selling a Rental Property?
When selling your investment property, you will have to pay tax on the gains that you earn. In “tax lingo”, that means you’ll have to pay tax on the profit you realize. The profit that you make in selling your investment property is taxed by the IRS in two ways:
- Capital Gains Tax (Rate: 0%, 15%, or 20%)
- Depreciation Recapture Tax (Rate: 25%)
What are Capital Gains Taxes?
If your investment property is sold at a price that’s higher than what you paid for it, you will have a capital gain. Capital gains can be classified into two — short-term and long-term.
Short-term capital gains are applicable to investment properties that you owned for less than one year. This type of capital gain is taxable as ordinary income. That means that the tax rate will be the same as the tax rate for wages.
Flipped houses are a common example of properties that are considered short-term gains because they’re investments that are rarely held for more than a year.
On the other hand, if you owned the property for at least a year, you will have what’s called a long-term capital gain. This is taxed at 0%, 15%, or 20%, the rate largely depending on your taxable income and filing status.
How Do You Calculate Your Capital Gains?
To calculate the capital gains, you will need to deduct the cost basis of the investment property from the net proceeds of the sale. The cost basis, or simply “basis”, is the original cost of the investment property plus any costs related to the investment (e.g., appraisal fees, costs for improvements, etc.).
For example, if you bought a property for $300,000 and spent $20,000 on improvements, your cost basis would be $320,000.
It’s worth mentioning that improvements are limited to projects that add value to the property. These include a kitchen remodel, roof installation, and so on. Maintenance and cosmetic changes (e.g. painting the walls, landscaping, etc.) are not included.
If you’ve hired a property management company, be sure to inquire about the improvements that were done to the property.
How Do You Adjust the Cost Basis of the Rental Property?
It’s important to adjust the cost basis of your investment property as this decreases the overall tax that you owe.
As mentioned earlier, the cost basis is the original price of the property plus improvements. However, the cost basis is not fixed. Reductions in basis will increase your tax liability, while increases in basis will reduce your tax liability.
#1 Reductions in Basis
Here’s what you can subtract from the basis of your investment property:
- For every year that you owned the property, depreciation should be subtracted from its basis.
- Insurance payments and reimbursements. For instance, if an appliance was stolen from your rental property, you may subtract the amount of the reimbursement received from your basis.
- Section 179 deduction. This includes items that are essential to the rental property, such as appliances, window coverings, etc.
#2 Increase in Basis
Increasing the basis reduces your taxable capital gains. As a rule of thumb, anything that adds value to your investment property can be added to the basis. This includes:
- Essential improvements. Examples include a new roof, insulation upgrades, and the like.
- Money spent on repairs due to disasters. The money must have been used to restore the property to its original condition after disasters such as hurricanes, fires, floods, and so on.
- Cost to extend utility services. Examples include installing a septic system or extending the main water line.
- Legal fees. This includes the legal fees related to the property, such as the cost of preparing the purchase contract and perfecting the title.
There are other ways you can increase the basis of your property. These include assessments conducted by the city for improvements such as installing curbings or paving the street. If you’re unsure about the costs that can be added to your basis, consider consulting a real estate professional.
What’s the Best Way to Reduce Your Capital Gains Taxes?
Capital gains taxes can significantly reduce your profits. Fortunately, there are several ways to reduce your taxes — and even avoid them altogether.
#1 Convert it into a primary residence
You can avoid capital gains taxes by converting your rental property into your primary residence. This is because when you sell a primary residence, you won’t have to pay taxes on your gain. Under IRS Section 121, you may qualify for certain exclusions of up to $500,000 on capital gains.
#2 Tax-loss harvesting
Another way to lower your tax liability is to offset your gains from the sale with losses from other investments. For instance, if you had $50,000 in capital gains from the sale of your investment property, but you had $40,000 in losses from your stock investment, your capital gains would be reduced to $10,000.
#3 Installment sale
If your property is free of any mortgage, you can use the “installment sale” strategy to reduce the taxes that you owe when you sell the rental property. Essentially, you still need to pay your taxes, but the payments are spread out over a predetermined period.
Investing in real estate is one of the best ways to gain financial freedom. Aside from its impressive returns, it brings a variety of tax breaks that allow you to make the most out of your sale.
If you’re planning on selling your investment property, the professionals at Luxury Property Care can help. We have years of experience under our belt, allowing us to confidently navigate the real estate market. Whether you need advice on selling your property, or you need guidance in filing your taxes, we’re ready to help.