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How Do I Avoid Paying Capital Gains Tax On Rental Property

By David Krug David Krug is the CEO & President of Bankovia. He's a lifelong expat who has lived in the Philippines, Mexico, Thailand, and Colombia. When he's not reading about cryptocurrencies, he's researching the latest personal finance software. 7 minute read

How do I avoid paying capital gains tax on rental property? axes on capital gains are due when assets, such as rental houses, are sold for a profit, but there are ways to avoid paying them in some cases.

Buying rental properties and then selling them for a profit is a common approach to grow wealth, but you may find yourself owing money to the IRS if you do so. They are termed capital gains taxes, and they differ from regular income taxes in a significant way. These taxes can be avoided by property owners as well. Learn how to avoid paying capital gains tax on rental property in the following guide.

What are capital gains taxes?

If you’re thinking about making a real estate investment, you should bear in mind the potential tax implications. All money earned in the United States is taxed by the IRS. Paying taxes is a part of having a job, for instance. However, you are also taxed if the value of your assets rises and you sell them for a profit.

Capital assets are the assets you hold for your own use or for investment. You have a capital gain if you can resell the items for more than you spent for them, and you may be liable for taxes on that gain. However, capital gains are not taxed at the same rate as ordinary income. Rather, it is taxed as a capital gain.

When studying how to invest in real estate or other assets, you should be aware of two forms of capital gains taxes: the ordinary income tax and the alternative minimum tax. Long-term and short-term capital gains are taxed at different rates, depending on your tax bracket.

Because the government seeks to encourage long-term investment strategies like purchasing and holding, long-term capital gains are taxed at a lower rate.

How do capital gains on investment properties work?

Like other forms of investment, such as stocks, investment properties are capital assets. You’ll have to pay capital gains taxes if you sell them for a profit. The asset basis or cost basis is necessary before you can figure out if you made a profit on the sale and how much of that profit is taxable income. Use these words to express the overall cost of a property. They are tax terminology.

Asset basis or cost basis for most individuals is the purchase price of the property, plus transaction fees and the cost of substantial renovations. The complete price you paid for the item, including any loans you took out to pay for it, as well as any commissions and fees associated with the transaction, is included here. A new roof or a new kitchen are examples of home improvements that might increase the value of your home.

There may be an “adjusted basis”, however, if you received the investment property as an inheritance or as a gift. It is possible to determine your gains by utilizing the fair market value of the property at the time of the inheritance, as well as other methods.

When selling a home, you need to know how much money you’ll make. This is your net profit after all fees, commissions, and expenses have been deducted. Capital gains taxes are calculated based on the difference between the cost basis and the net proceeds.

As an illustration, let’s say you paid $360,000 for a house, which includes the down payment and closing costs, and another $50,000 to improve it. After that, you resold it for $450,000, earning a profit of $5,000. Here’s how you’d figure out how much taxes you’ll owe, $5000 in transaction charges – $50,000 in considerable upgrade expenses – $360,000 total original purchase price, including transaction fees, for $450,000. $35,000 taxes on capital gains would be due on the $35,000 net profit.

It depends on your income whether you’d be subject to long-term capital gains tax on this $35,000 if you’d owned the property for more than a year. For example, if you held it for less than a year, you would be taxed at your regular income tax rate.

The net investment income tax of 3.8 percent may also apply if your modified adjusted gross income exceeds the following thresholds: $250,001 for married couples filing jointly; $125,000 for married separate filers; $250,001 for qualified widows or widowers with dependent children; or $200,000 for all other taxpayers. It doesn’t matter if you’re making short- or long-term gains; this rule applies to both.

Strategies to avoid capital gains on rental property

Here, you can see how the amount of profit you keep is affected by capital gains. Capital gains taxes can be avoided, though, if you rent out your property. Here are a few possibilities.

Offsetting losses with gains

Taxes on capital gains can be reduced by claiming capital losses. Selling an asset at a loss results in a loss of capital. You’ve lost $25 if you bought stock for $100 and it drops in value, causing you to sell it for $75.

In order to counter benefits, you must be aware of the losses and experience them firsthand. If the value of your stock decreased, for example, you would not be able to claim a loss. Consequently, you may decide to be strategic about the time you sell losing assets.

It’s possible to utilize losses from the sale of losing assets to offset gains from the sale of assets that are expected to appreciate in value within a given tax year. Tax-loss harvesting is a term for this. As long as you have capital losses to offset your gains, you’re good. As a result, if you earn $35,000 but lose $40,000, you won’t owe capital gains taxes on the $35,000 you made.

Married joint filers can additionally deduct up to $3,000 in capital losses from their ordinary taxable income each year when their losses outweigh their profits. For single taxpayers and married taxpayers filing separate returns, this amount drops to $1,500. If you have a lot of capital losses, you can also roll them over to the next year.

1031 exchanges

A further benefit of performing a 1031 exchange is the potential avoidance of capital gains taxes. Using the profits from the sale to acquire another property, known as a replacement property, is known as a 1031 exchange under Section 1031 of the federal tax law. If you’re trading real estate, you must ensure that the property you’re getting is of a like-kind kind and type to the one you just sold. To meet this criterion, you might purchase another rental property for the same or greater money.

You also have a limited amount of time in which you can use the money from the sale of your present home to acquire another property. As a rule of thumb, you must find a new home within 45 days of selling your current home, and you must close on that new home within 180 days of selling your current home.

As a result, you are unable to assume direct possession of the selling earnings until you have acquired a new home. Using an intermediary, like an escrow corporation, can assist you to avoid getting into difficulty with this part of the procedure.

Convert your rental to a primary residence

In terms of capital gains and house sales tax, primary residences are subject to different restrictions than rental properties. A rental home can be turned into a primary residence, but only if certain conditions are met. Two of the five years prior to selling must have been spent living in the house and using it as your primary residence.

Depreciation claims made while the property was being used as a rental must be recovered and a flat 25% tax must be paid on them if the property is later converted to the main home. Depreciation recapture tax is 25% of $5,000, or $1,250, for example, if you deducted $5,000 for depreciation when renting out the property.

Gains of up to $250,000 for single filers and up to $500,000 for married couples filing joint returns can be deducted if the rental property is converted to a main home before it is sold.
Any principal residence is exempt from these limitations. Because of this, your earnings are exempt from capital gains taxes. However, if you have previously excluded the sale of another property in the two years before the sale of this property, you cannot claim this exception.

Buy properties with your retirement account

Taxes on capital gains can be deferred if assets are held in a tax-qualified retirement plan such as a 401(k), regular IRA, or Roth IRA.

A self-directed retirement account is the only type that permits real estate investment. The majority of businesses and individual retirement plans are not self-directed, thus you cannot invest in real estate. You may create self-directed accounts with several financial institutions that allow you to invest in any asset, including real estate.

You must also keep a safe distance from your investment, which means that neither you nor any of your close family members should be able to occupy or manage the property. All of the property’s revenues must be reinvested in the retirement fund.

Bottom line

If you’re a successful real estate investor, capital gains tax may eat into your winnings. However, as you can see, as the value of your property increases, there are several strategies to reduce your tax burden. It’s possible to save money on your taxes by using the best tax software, which you can get online, or by working with an experienced real estate tax consultant.

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