The goal of every investor when selling an investment property is to earn the highest possible return on it. Between the time that they buy the property and the sale of it, the value of the property typically increases. If upon sale, the investor makes a gain out of their investment, they will have to pay capital gain tax on the profit realized.
Capital gain tax is the tax paid when an asset such as an investment property is sold at a price higher than it was bought for initially. Depending on the gain, capital gain taxes can take a considerable amount from your profit. That is why investors are constantly looking for strategies to lower or even avoid the capital gain tax completely when investing in a rental property. You can calculate the capital gain tax on your investment property, based on your income, filing status, and length of ownership of the property.
If you are looking to minimize the capital gain tax on your rental properties, there are a few techniques you can consider and things to keep in mind:
1) Avoid short-term gains
Capital gains are classified into two categories: short-term capital gains and long-term capital gains. A short-term gain is realized when you purchase an investment property and sell it within one year. On the contrary, long-term gains are realized when you hold your investment property for more than a year and then sell it. These two types of gains are taxed differently, which is why the length of ownership is important.
The rate of the capital gain tax on short-term gains depends on the income level of the investor. Therefore, the rate ranges from 10% to 37% and this is why short-term capital gains taxes are typically higher than long-term capital gain taxes. The reasoning behind this is to encourage investors to hold their investments for a longer period of time, exceeding one year.
On the other hand, the tax rate on long-term capital gains can be either 0%, 15%, or 20%. The specific rate is determined by your income level and your filing status. It is obvious that taxes on long-term gains are lower. Therefore, if you wish to minimize the taxes you will pay on the capital gains realized, you should try to hold your investment property for more than one year before selling it.
2) Turn investment property into a primary residence
If you sell your primary residence, you are allowed to exclude up to $250,000 from your capital gains taxes, or an amount of $500,000 if you are married and you are filing jointly. This benefit is not available for investment properties. Keep in mind that for a house to be considered a primary residence, there are a couple of conditions that have to be met, such as using the house for at least 2 years as a primary residence out of a 5-year consecutive period.
Obviously, if you are investing in several rental properties, it is impossible to use this technique for all of them. However, you can leverage this alternative for an investment property that has great capital gains potential.
3) Use a retirement account to purchase the investment property
Retirement accounts, such as 401(k) and IRAs, allow investors to accumulate rental income and capital gains in the accounts without being taxed. The only time you are taxed on this money is when you withdraw it from the account. If you use these types of tax-deferred retirement accounts to purchase your investment property, then you can avoid paying capital gain taxes for a period of time. Once you retire, you can withdraw the accumulated money and pay taxes at a lower tax bracket.
4) Offset gains with losses
Short- and long-term capital gains on certain properties can be offset by short- and long-term losses on other properties. Therefore, if you make a capital gain of $2000 on investment and incur a loss of $2,500 on another one, you can completely avoid paying any capital gain taxes on the investment that was sold at a profit.
Keep in mind that you can only claim an amount of loss up to $3,000 in a particular year. Therefore, if in any year, you incur a bigger loss than $3,000 and you use it to offset the gains for that year, you can carry forward the remaining loss to use it towards capital gains in future years.
5) Sell when your income is low
As we mentioned at the beginning of this article, the amount of capital gains taxes you pay largely depends on your income level. Therefore, if other conditions are favorable and during a certain year, you experience a loss in income, large enough to cause a change in the tax bracket your income classifies for, you should sell your investment property during this time. Doing so would reduce the capital gains you would have otherwise paid if your income was larger.
6) 1031 Tax Deferred Exchange
For investors who wish to sell an investment property and purchase another one of similar value, section ‘1031’ of the U.S. Internal Revenue code allows them to do so without paying capital gains on the sale of the initial property. In other words, if you sell a property and use the funds to purchase another like-kind property, you will not be taxed on the capital gain realized. This is a very useful technique that gives investors the opportunity to grow their wealth without taking from the gains they make on every property’s sale.
7) Home Renovations
Your capital gain is calculated by deducting the adjusted basis of the property from its selling price. The adjusted basis includes the initial price of the property, legal costs, title insurance, sale commission expenses, and property improvement costs. Therefore, by renovating a property, you would be able to increase the adjusted basis of your property and therefore realize a smaller capital gain. Of course, depending on the cost of home renovations and how they affect the selling price of the property, your capital gain will be determined.
In conclusion, capital gain taxes can take a big chunk out of your profit on an investment property. Therefore, researching and considering strategies to minimize the capital gain tax before you sell your property can prove to be worth it.