When you sell an investment property, you may be subject to capital gains taxes on the profit you make from the sale. Capital gains tax applies to the profit earned from the sale of a property that has appreciated in value since its purchase. However, the tax rate and specific rules depend on several factors, including the length of time you’ve owned the property, how the property is used, and your tax bracket.
This guide will help you understand how capital gains taxes apply to investment properties, as well as potential strategies to minimize your tax liability.
What Are Capital Gains Taxes?
Capital gains tax is the tax imposed on the profit made from the sale of an asset, such as real estate. In the case of investment properties, the tax applies to the difference between the property’s sale price and its original purchase price (adjusted for any improvements or deductions). If the property has increased in value, the profit is considered a capital gain.
Short-Term vs. Long-Term Capital Gains
The IRS distinguishes between short-term and long-term capital gains based on how long you’ve held the property before selling it:
Short-Term Capital Gains
If you sell the property within one year of purchase, the gain is classified as short-term. Short-term capital gains are taxed at your ordinary income tax rate, which can be as high as 37% (depending on your tax bracket).
Long-Term Capital Gains
If you hold the property for more than one year, the gain is classified as long-term. Long-term capital gains are taxed at a lower rate, ranging from 0% to 20%, depending on your income level. Additionally, the Net Investment Income Tax (NIIT) may apply, which is an additional 3.8% tax on certain investment income for higher-income individuals.
Capital Gains Tax Rates for Investment Properties
The tax rates for long-term capital gains on investment properties are structured as follows:
0%: For individuals in the lowest tax brackets (typically those with taxable income below $44,625 for single filers or $89,250 for married couples filing jointly).
15%: For individuals in the middle tax brackets (taxable income between $44,626 and $492,300 for single filers or $89,251 and $553,850 for married couples filing jointly).
20%: For individuals in the highest tax brackets (taxable income above $492,300 for single filers or $553,850 for married couples filing jointly).
For higher-income earners, the Net Investment Income Tax (NIIT) of 3.8% may also apply to the capital gains, adding an additional layer of taxation.
Factors That Affect Capital Gains Taxes on Investment Properties
Several factors can impact the amount of capital gains tax you owe when selling an investment property:
Property Sale Price and Purchase Price
The capital gain is determined by subtracting your adjusted basis (purchase price plus any capital improvements) from the sale price. If you sell at a loss or break even, there is no capital gains tax.
Depreciation Recapture
If you have claimed depreciation on your investment property during your ownership, you may be subject to depreciation recapture when you sell the property. Depreciation is a tax deduction that allows you to deduct a portion of the property’s value each year as it wears down. However, when you sell, the IRS requires you to “recapture” that depreciation and pay tax on it.
Depreciation recapture is taxed at a maximum rate of 25%.
Capital Improvements
Any capital improvements you’ve made to the property (such as adding a new roof or renovating the kitchen) can be added to your basis, reducing your taxable gain when you sell the property. Regular maintenance and repairs, however, are not considered capital improvements and cannot be added to the basis.
Exemptions and Deductions
Certain exemptions and deductions may help reduce the taxable gain. For instance, if the property was your primary residence for at least two of the last five years, you may qualify for the Section 121 Exclusion, which allows you to exclude up to $250,000 of gain ($500,000 for married couples) from the sale.
1031 Exchange
A 1031 exchange allows you to defer paying capital gains taxes if you reinvest the proceeds from the sale of one investment property into a like-kind property. This is a popular strategy for real estate investors who wish to defer taxes and continue growing their portfolio.
The new property must be similar in nature and use to the one you’re selling.
The process must be completed within strict timelines set by the IRS.
Strategies to Minimize Capital Gains Taxes on Investment Properties
Hold the Property Long-Term
One of the easiest ways to reduce your capital gains tax liability is by holding your investment property for more than one year. This qualifies you for the long-term capital gains tax rate, which is generally lower than the short-term rate.
Use a 1031 Exchange
As mentioned, a 1031 exchange can help you defer capital gains taxes by reinvesting the proceeds into another similar property. This strategy is particularly useful for investors looking to defer taxes while upgrading or diversifying their property holdings.
Offset Gains with Losses (Tax-Loss Harvesting)
If you have other investment properties or assets that have declined in value, you can sell them at a loss to offset the gains on your profitable property. This is known as tax-loss harvesting and can reduce your overall tax liability.
Invest in Opportunity Zones
Opportunity Zones are designated areas where the government provides tax incentives for investments. If you invest in property in an Opportunity Zone, you may be able to exclude or defer capital gains taxes. This option is best for long-term investors seeking tax benefits while contributing to community development.
Maximize Deductions and Write-Offs
Keep detailed records of all capital improvements and expenses related to the property. These can help lower your adjusted basis and reduce your taxable gain when you sell the property. Deductions like property management fees, repairs, insurance, and mortgage interest may all be applicable.
Conclusion
Capital gains taxes on investment properties can significantly impact your profits when you sell, but understanding the rules and using strategic tax planning can help reduce the amount you owe. Holding the property long-term, utilizing tax-deferred strategies like 1031 exchanges, and making the most of available deductions can all help you minimize capital gains tax liability.
For real estate investors, it’s essential to work with a knowledgeable tax professional or real estate advisor to ensure you’re making the most of available opportunities and reducing your tax burden when selling investment properties.