Selling Investment Property: Your Guide to the Tax Implications

So you sold a property this year. Congratulations!

This cause for celebration also adds a few tasks to this year's tax season checklist—though nothing you can’t handle. Selling an investment property means you have a couple more tax hoops to jump through, and it’s vital you carefully file everything correctly to avoid legal penalties. This article will guide you through everything you need to know about the tax liability that comes with selling investment property.

Capital Gains on Rental Property

A capital gain, per the Internal Revenue Service (IRS), is any amount of money earned from the sale of an asset. Assets can include appliances, vehicles, stocks, and more, but for the purpose of this article we’re going to focus on residential property assets.

You are required by law to report any capital gains you earn to the IRS each year. Failure to report and pay this tax will result in penalties such as fines, civil charges, and even tax liens if neglected for too long. It’s best to understand the intricacies of reporting capital gains to avoid the headache.

Terms to Know

Before getting started, there are a key terms you need to be familiar with a few of the terms we’ll use (if you aren’t already). They aren’t rocket science by any means, but it’s good to clear any and all confusion before we get started.

As a starting point, here are a few terms to brush up on:

• Non-adjusted basis: The value of an asset based only on the purchase price.
• Adjusted basis: The value of an asset after time, modifications, and other changes have been factored into the purchase price.
• Capital gain: The amount of money earned from the sale of an asset.
• Capital loss: Money lost from an asset’s sale (if you sell for less than you purchased).
• Capital gains tax: The rate at which your capital gains will be taxed, which depends on your filing status, tax bracket, and overall taxable income.

Now, we’re ready to dive right into some key considerations for tax season.

Types of Capital Gains Tax on Rental Property

Depending on how long you’ve owned the rental property, the type of capital gain you report will be different. This also depends on whether or not you sell the property for more than its adjusted basis.

Generally, there are two types of capital gains for rental property:

• Short-term capital gains: This applies if you’ve owned the property for one year or less, and it means that any profits earned are treated as ordinary income (and therefore taxed at ordinary income tax rates). This varies by tax bracket, but typically ranges from 10%–37%.
• Long-term capital gains: This applies if you’ve owned the property for more than one year, and it means that your profits won’t be treated as regular income. Individual rates also vary, but they tend to sit around 0%–20% (with most under 15%).

To set your expectations accurately, we recommend taking a look at the official tax bracket information released by the IRS.

How to Avoid Capital Gains Tax When Selling Investment Property

If you’re worried about a 20% tax hit on your gains from a sale, not to worry. As we’ve seen, there are a number of factors that play into exactly how much you’ll be taxed, so it likely won’t be that high.

Plus, there are a few tax rules and loopholes you may be able to utilize that allow you to get the most preferential rates possible. Here are a few.

Home Sale Exclusion

This tax loophole only applies if the property you sold served as your primary residence for at least two of the five years preceding its sale. If this applies to you, then:

• For those filing single, profits of up to $250,000 are not taxed
• For married couples filing jointly, profits of up to $500,000 are not taxed

This is a pretty big tax break. If you plan on selling a rental property in a few years, some experts recommend selling your current residence now (which would qualify for this exclusion), and turning the rental property into your primary residence. Then, once you’re ready to sell the property, you’ll be able to qualify for the exclusion again. (Take note, though, that you can’t use this exemption more than once every two years.)

Use a 1031 Exchange

You can also delay or soften the blow of capital gains tax by using a 1031 exchange (named after Section 1031 of the IRS tax code). This essentially allows you to temporarily dodge the tax if you quickly reinvest in another like-kind replacement property which is defined by the IRS as one “of the same nature or character, even if they differ in grade or quality.” For example, you could swap one apartment building for another, but you couldn’t swap for one in another country.

There are some specific holding period rules to adhere to if you’re looking to use a 1031 exchange, though. They include:

• Within 45 days of the original property’s sale, a like-kind real estate must be identified and acquired within 180 days
• The funds used to purchase the like-kind real estate must be acquired from the original sale
• Investors must report overflow cash or mortgage differences, called “boot,” this amount is likely taxable

1031 exchanges are very complex though, and if you plan to utilize this loophole, it’s best that you have a seasoned tax professional guide you through it. Making an accidental misstep can be costly.

Tax-Loss Harvesting

This valuable strategy is a bit trickier, and it requires multiple moving parts to do correctly. Basically, this requires you to take a loss on other investments, which you can then report. This will offset your capital gains, lowering your taxable income.

If, for example, you have a stock performing poorly that you are looking to get rid of, do so in the same year you sell your investment property. That way, the realized losses from your stock can be reported as capital losses. Remember, to qualify as a capital loss, the stock must be sold for less than its adjusted basis.

Like most tax regulations, tax-loss harvesting has its own complexities and limits. You may not be able to deduct all of your capital losses if they exceed your gains, as there are caps and various rules preventing this. As always, consult tax professionals when in doubt.

Other Tax Considerations

Capital tax gains are just the first tax hurdle. There are a few other pieces of the tax landscape that we’ll cover in this next section.

Depreciation Deductions & Recapture

Rental properties (the physical structures, not the land they are on) have a depreciation period of 27.5 years. This means that you can deduct a percentage of the unadjusted cost basis each year on your taxes, thus lowering your overall taxable income.

However, this doesn’t go on indefinitely. When you sell the property in question, there’s something called recapture, which is essentially a reclaiming of the difference. If you’ve deducted portions of your rental property’s value over the years, the IRS will tax you on the difference between the book value (the portion you’ve not depreciated) and the selling price. This is governed by a complex set of rules, so it’s worth investigating.

Net Investment Income Tax (NIIT)

Depending on your income, you may also be subject to the Net Investment Income Tax (NIIT). It’s an extra 3.8% tax added to your investment income, but it only applies to certain tax brackets.

You have to pay this tax on top of others if your Modified Adjusted Gross Income (MAGI) is more than:

• For those filing single, $200,000
• For married couples filing jointly, $250,000
• For married couples filing separately, $125,000 each

If you’ve sold a property in the past year (and not bought another like-kind property), then there’s a good chance you’re subject to this tax.

Take the Right Next Steps

Although selling property complicates your taxes a bit, putting in the work to save as much of your real estate portfolio’s profit as possible is worth it. Fulfilling your tax obligations while retaining as much of your rental income as possible is very attainable.

Don’t be afraid to take advantage of the various tax opportunities available to you. Certified tax professionals can help you carefully make informed decisions and save even more than you thought possible.

Plus, to keep your receipts, invoices, and other documents at the ready for tax season, consider simplifying your business with paperless rental property management software.

FAQs

How to avoid capital gains tax when selling investment property?

You may be able to reduce or defer capital gains tax by using the home sale exclusion (if it was your primary residence for 2 of the last 5 years), completing a 1031 exchange with a like-kind replacement property within the IRS timelines (45-day identification and 180-day purchase), or using tax-loss harvesting to offset gains with a capital loss from other investments.

What is a capital gains tax on rental property?

Capital gains tax on rental property is the tax you pay on profit when you sell a rental for more than its adjusted basis. The rate depends on your holding period: short-term gains (1 year or less) are taxed at ordinary income tax rates, while long-term gains (more than 1 year) generally receive more preferential rates.

What are the taxes associated with selling investment property?

Taxes can include capital gains tax (short-term or long-term), depreciation recapture on prior depreciation deductions, and the Net Investment Income Tax (NIIT) (an additional 3.8%) if your MAGI exceeds IRS thresholds.

What are capital gains on rental property?

Capital gains on rental property are the profits you earn from selling the property for more than its adjusted basis (the value after time and changes are factored into the purchase price). These gains must be reported to the IRS and are taxed as short-term or long-term depending on how long you owned the property.