If you buy an investment property, you do so with the expectation of making money. After all, with the right property you can enjoy a steady revenue stream each month that more than covers your mortgage and other expenses. What’s more, you can cash in on all that appreciation when it’s time to sell.
Of course, the IRS will want a chunk of those sale proceeds. Cue the capital gains tax. Here’s what you need to know about these taxes and what you can do to reduce them.
What are capital gains taxes?
If you sell an investment property for more than you paid for it, you have what’s called a capital gain. There are two types of capital gains -- short-term and long-term -- and they’re treated differently at tax time.
Short-term capital gains happen when you sell an investment property you held for one year or less. These gains are taxed as ordinary income. That means you pay the same tax rate on short-term gains as you would on wages from your job. For 2019, there are seven tax brackets that range from 10% to 37%.
Profits on flipped houses are treated as short-term gains since investors tend to get in and out of these investments quickly. In general, most other types of investment properties are held for at least a year, which allows investors to take advantage of the lower long-term capital gains tax rates.
If you hold the property for at least a year, it’s considered a long-term capital gain. These gains are taxed at a lower rate: 0%, 15%, or 20%, depending on your income and filing status. Here’s a look at long-term capital gains tax rates for 2019:
|Filing Status||0% Rate Applies||15% Rate Applies||20% Rate Applies|
|Single||Up to $39,375||$39,376 to $434,550||Over $434,550|
|Married (filing jointly)||Up to $78,750||$78,751 to $488,850||Over $488,850|
|Head of household||Up to $52,750||$52,751 to $461,700||Over $461,700|
|Married (filing separately)||Up to $39,375||$39,376 to $244,425||Over $244,425|
If you’re a higher-income investor an additional 3.8% net investment income tax may apply. That’s true whether you have a short-term or long-term gain. You’ll owe the tax if you have net investment income and your modified adjusted gross income is over:
- $250,000 if you’re married and filing jointly
- $125,000 if you’re married and filing separately
- $200,000 if you’re a single filer
- $200,000 for heads of households
- $250,000 for qualifying widow(er)s with dependent children
How to calculate capital gains
When you sell an investment property, any profits are subject to capital gains taxes. But it’s not as simple as subtracting what you paid for the property from what you sold it for. Instead, you calculate the capital gain (or loss) by subtracting the “cost basis” of the property from the “net proceeds” you make from the sale. This means your profit -- and tax burden -- might be smaller than it seems at first glance.
Cost basis of investment property
The cost basis is the amount you paid for the property, plus:
- Legitimate costs related to the purchase (e.g., some closing costs, appraisal fees, and legal fees).
- The cost of any major improvements you made to the property.
For example, if you paid $200,000 for the property, had $5,000 in closing costs, and spent $20,000 on improvements, your cost basis would be $225,000 ($200,000 plus $5,000 plus $20,000).
Improvements must add value to the property, change its use, or make it last longer. Things like a new roof, an addition (such as a family room), or a kitchen remodel count as improvements. Routine maintenance and anything you do simply to make the property look better (e.g., purely cosmetic changes like painting the bedrooms) don’t count.
Net proceeds from investment property
When you sell your property, you don’t really receive the full sales price. That’s because there are costs associated with the sale -- such as the real estate agent’s commission, home staging, house cleaning, lawyer fees, and transfer taxes.
You get to subtract the costs from the sales price to determine your net sales proceeds. If you sold your investment property for $300,000, for instance, and you paid $18,000 in commissions and $4,000 in other costs, your net sales proceeds would be $278,000 ($300,000 minus $18,000 minus $4,000).
To calculate the capital gain on the property, subtract the cost basis from the net proceeds. If it’s a negative number, you have a loss. But if it’s a positive number, you have a gain.
Using the above examples, if you have a cost basis of $225,000 and net proceeds of $278,000, your capital gain on the property would be $53,000. And this would be the amount that your capital gains tax is based on. If you fall under the 15% long-term capital gains rate, you would owe $7,950 ($53,000 multiplied by 15%).
How to reduce or avoid capital gains taxes
Capital gains taxes can take a significant bite out of your profits. But there are ways to reduce or even avoid these taxes on the proceeds from the sale. Here are three strategies.
1. Turn your investment property into your primary residence
The easiest way to limit or avoid the capital gains tax is to convert your investment property to your primary residence. The reason? If you sell a primary residence, you don’t have to pay taxes on the entire gain. That’s because IRS Section 121 lets you exclude up to:
- $250,000 of capital gains on real estate if you’re a single filer.
- $500,000 of capital gains on real estate if you’re married and filing jointly.
To count as your primary residence, you must own and live in the house for at least two of the five years immediately preceding the sale. Say, for example, that you bought an investment property in 2010, and in 2015 you converted it to your primary residence. In other words, you moved in and called it home. In 2019, you can then sell the property as a primary residence because you lived in it (and owned it) for at least two out of the previous five years.
2. Offset gains with losses
Another way to lower your tax liability when you sell investment property is to pair the gain from the sale with losses from your other investments. This strategy is called tax-loss harvesting.
The IRS aggregates your gains and losses for the year. So even if you sell your investment property at a profit, you can offset those gains by losses you had in, say, the stock market. For example, if you had $53,000 in capital gains from selling your investment property, and in the same tax year had $50,000 in losses from a bad stock investment, your capital gains would be limited to just $3,000.
One caveat to know: The tax code requires that short-term and long-term losses get used first to offset gains of the same type. But if your short-term losses exceed your short-term gains, you can apply the excess short-term losses to any long-term gains. Likewise, if your long-term losses are greater than your long-term gains, you can apply the excess long-term losses to any short-term gains.
3. Take advantage of a Section 1031 exchange
If you want to sell an investment property -- but don’t need to cash out just yet -- you can defer paying capital gains taxes by doing a like-kind exchange.
Section 1031 is a provision of the U.S. tax code that lets you sell an investment property (called the “relinquished property”), buy a “like-kind” property, and defer paying taxes. This process is called a 1031 Exchange, a Starker Exchange, or a like-kind exchange. In most cases, a Qualified Intermediary (QI) acts as a third-party facilitator to ensure the process goes smoothly.
To qualify as a like-kind property, it must be real property (i.e., real estate) that you’ve held for productive use in a trade for business or for an investment. Personal residences don’t count. Neither do vacation homes.
There are strict time limits for 1031 exchanges. After you sell your investment property, you have 45 days to identify up to three like-kind exchange properties.
After that, you must close on the new property within 180 days of selling your investment property, or before your tax return is due for the year you sold the property -- whichever comes first. If you don’t meet these deadlines, the transaction won’t count as a 1031 exchange and any capital gains taxes will become due.
Capital gains taxes can take a big bite out of your profits when it comes time to sell your investment property. Fortunately, there are ways to lower and defer these taxes. Taxes are complicated and rules change, so it’s always recommended that you work with a qualified tax specialist to make sure you receive the most favorable tax treatment possible.