A rental property is a great form of passive investment. Accrue enough properties and you can even make real estate investment your primary source of income! One of the best parts of real estate investment is that property has a low correlation with other sectors of the economy, so you’re likely to weather economic hard times. Plus, when the going gets tough the tough start renting. That means an economic hard time may even be boon for a landlord!
When it comes to selling rental properties, however, it’s possible to lose a significant portion of one’s profits. Luckily, there are many ways to get around paying the maximum amount of taxes. These methods can also figure into a larger investment strategy, or even factor into how you want to live your life in general.
What is Capital Gains Tax (CGT)?
The profit you make when an asset is sold is known as a capital gain. Capital gains tax (CGT) is the 15% you pay on that profit. If your profit is $100,000, your CGT is going to be $15,000 (15% of $100,000). That’s a significant number, so, as you can imagine, there are ways of making the CGT your responsibility for smaller.
Are there specific exemptions for an investment property?
There are three ways people go about reducing their CGT: reduce, exclude, or defer. This entails maximizing your cost basis, which is how much you paid for your property initially; making your rental property into your primary residence; and performing a 1031 exchange.
Offset Gains with Losses
You can pair your gains with losses you incur in other areas of your investment. This is known as tax-loss harvesting. This practice is often employed at the end of the year to decrease the CGT on stock gains, but tax-loss harvesting can just as easily be applied to profits made from selling rental properties.
Is there a Tax Limit on Losses?
If you or your spouse are active participants in a passive real estate business, like a rental property, then the limit on your losses is $25,000 per year. The remainder can be deducted against the following year. This can be kept up every year until you finally sell your property, at which point you can recapture the total remaining losses against the profits you make from your sale.
Take Advantage of Section 1031 of the Tax Code
A 1031 exchange is when you use the profits from the sale of your property to purchase a property (or properties) of equal or greater value soon after. A 1031 exchange is a great way to diversify your portfolio or get a property that requires less maintenance.
You can keep doing 1031 exchanges for years! And if you die before ever finally just taking the profits you made and then paying the taxes you owe, your heirs get your property without having to pay those deferred taxes! They may, however, have to pay the estate tax, so consulting with a financial planner is a good idea.
Know the Deadline
A 1031 exchange is not as simple as simply buying a property that’s of equal or greater value to your previous property. You have to do all this within a specific time frame. Within 45 days of the initial sale you need to have identified potential properties to purchase. And within 180 days of starting the entire process you need to have completed the entire exchange. The exception is that if your tax return deadline is before your 180 days are up then you must complete the exchange before the tax return deadline is reached.
Tax Loss Harvesting
Simply put, the losses you incur in one part of your investment portfolio can lower your CGT. You can even sell things at a loss on purpose! So, if you owe $100,000 in CGT after selling a rental property, you can sell off a bunch of stocks at a loss of $25,000 and then owe $75,000 in CGT!
Turn Your Rental Property into Your Primary Residence
IRS Section 121 lets you exclude a large portion of the sale from a primary residency from CGT: $250,000 for singles and $500,000 for married couples filing jointly. In order to make use of this benefit, you must have owned the home for at least five years and lived in it for at least two years out of those five. The size of your deduction will stem from how long it was used as a rental property relative to a primary residence.
How much will I have to pay?
Here’s some simple math to show you how turning a rental property into a primary property can save you money. If you sold a $200,000 house for $300,000 that means you made a $100,000 capital gain. You’ve owned the property for five years but lived in it for two. That means you divide your capital gains by 40% (2/5) and that’s how you find out the amount you can have deducted. That leaves you with 60k that will be subjected to capital gains.
Knowing your end game can help shape your opening gambit. As a result, you can now keep in mind how you want to deal with your taxes when you start to craft your investment strategy. Maybe you’ll purchase a rental property you wouldn’t one day mind living in. Or maybe you’ll diversify your investment portfolio so that you can pair your losses with any gains you make from selling your investment property. No matter which way you go at least now you know your destination.