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Tax season can often be a stressful time for real estate investors. In particular, if you've sold an investment property in the last year, you need to be aware of the capital gains rate. Read on below to learn what the capital gains tax is and how much is capital gains tax this year. Armed with this knowledge, you should have a much better idea of how much you stand to owe on your tax bill and how to reduce it as far as possible.
What is the capital gains tax?
At its core, the capital gains tax is levied on profits from the sale of a capital asset. The asset could be anything from shares of stock to a piece of real estate, the sale of an income-producing business, or a work of art.
Generally, a capital gain is realized whenever an asset is sold for a price higher than its tax basis. Meanwhile, a capital loss occurs when an asset is sold for less than its tax basis. In both cases, the tax basis is defined as an asset's purchase price, plus commissions and the cost of improvements, minus depreciation.
However, what sets capital income apart from any other taxable income listed on your tax return is that, in this case, you'll be taxed differently, based on how long you held the asset in your possession. Short-term capital gains, or income from the sale of assets held for less than one year, are taxed at the ordinary income tax rate. However, capital income held for longer than that one-year threshold is typically taxed at a lower, long-term capital gain rate.
What's the long-term capital gain tax rate for the 2021 tax year?
If you have to pay capital gains tax on a capital asset you held for longer than one year, the amount you pay will ultimately depend on your tax bracket. However, it won't be exactly the same as the tax rate on your ordinary income.
The Tax Cuts and Jobs Act of 2017 effectively decoupled those two sets of tax brackets. Here are the long-term capital gains tax brackets by income for 2021:
- If your income is $40,400 or less: 0%
- If your income is between $40,401 - $445,850: 15%
- If your income is greater than $445,850: 20%
For those married filing jointly
- If your income is $80,800 or less: 0%
- If your income is between $80,801 - $501,600: 15%
- If your income is greater than $501,600: 20%
For heads of household
- If your income is $54,100 or less: 0%
- If your income is between $54,101 - $473,750: 15%
- If your income is greater than $473,750: 20%
Those who are married filing separately
- If your income is $40,400 or less: 0%
- If your income is between $40,401 - $250,800: 15%
- If your income is greater than $250,800: 20%
What's the short-term capital gain tax rate for the 2021 tax year?
The short-term capital gains tax rate is the same rate as your ordinary income according to federal income tax brackets. As of the passage of the Tax Cuts and Jobs Act of 2017, there are seven tax brackets in total, ranging from 10% to 37%.
If you need to know where you fall based on your taxable income, check out our 2021 income tax bracket resource here.
Understanding the net investment income tax
In addition to the capital gains tax rates listed above, some high-net-worth individuals also have to worry about the net investment income tax. The net investment income tax is an additional 3.8% tax that helps fund the Affordable Care Act and applies to any income from investments, provided you make over $200,000 as a single filer or $250,000 if married filing jointly.
In effect, this added tax on your capital gains income raises each capital gains tax rate by 3.8%. For long-term capital gains, the maximum tax rate becomes 23.8% as opposed to 20%. Additionally, for short-term capital gains, the maximum federal income tax rate becomes 40.8% rather than 37%.
Strategies to minimize your tax bill as a real estate investor
Now that you know more about how capital income is taxed, it's time to take a look at some strategies that will help you minimize your tax bill. Here are four strategies real estate investors can use to reduce the amount they pay in capital gains tax:
- Make the home your primary residence: By now, you probably know the sale of your primary residence counts for a capital gains tax exclusion on up to $250,000 worth of profit ($500,000 if you are married filing jointly). You can take advantage of this exclusion if you live in the property for at least two years before you sell it.
- Do a 1031 exchange: Doing a 1031 exchange allows you to use the profits from the sale of an investment property to buy a new one, effectively deferring capital gains taxes until the new property is sold. That said, there are a lot of rules and stipulations around 1031 exchanges, so if you're thinking of going this route, it's best to see a professional for tax advice.
- Invest through an IRA: Some self-directed IRAs allow investors to use their funds to invest in real estate, which makes this a smart strategy since investments sold within a retirement account aren't subject to capital gains tax. However, there are rules around investing in this manner, so do your research first.
- Use tax-loss harvesting: If you sell other assets like stocks at a loss, you can use those losses to offset your capital gains. This strategy is known as tax-loss harvesting.
The bottom line
The government may tax capital gains on the sale of real estate, but that doesn't mean you have to pay the full capital gains rate every year you sell a property. Instead, take a closer look at some of the strategies we've listed above. With their help and that of a qualified tax professional, you should successfully be able to defer or reduce the amount you owe.
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