by Ben Luxon November 13, 2019 6 min read

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What is capital gains tax?

Capital gains tax, in short, is the tax paid on profits made from the sale of an asset. This asset can be anything, for example, a piece of art, a classic car, or in this scenario a property. 

When you sell your asset for a profit, the money made in the sale needs to be reported to the IRS as taxable income for that tax year. This money will be taxed at either the long term or short term capital gains rate depending on how long you hold the asset before the sale. It is a little more complex than this, and it is always a good idea to consult with a licensed professional to discuss the best course of action dependent on your individual scenario.

Capital gains tax on rental properties vs. your primary residence

The IRS allows $250,000 of tax free profit on a primary residence. What this means, in a simplified sense, is if you bought your primary residence for $300,000 in 2010, lived in it for 8 years, and then sold it in 2018 for $550,000, you wouldn’t have to pay any capital gains tax. This amount is doubled if you are married.

Compared to this, for a rental property, you have to pay capital gains tax, dependent on your personal tax bracket (see below), on all profit made after the sale of your investment profit.

There is another thing to take into consideration, long term gains are taxed at a favorable reduced rate compared to short term gains which are taxed at your personal income rates. An asset qualifies for the long term gains rates if you hold if for longer than 12 months.

capital gains tax

Capital Gains Tax Rates

Single Filers (as a rough rule allowable income is double for married filers).

Income:$0.00 to $39,375            Long Term Capital Gains Rate: 0%

Income: $39,376 to $434,550      Long Term Capital Gains Rate: 15%

Income: $434,551 or more           Long Term Capital Gains Rate: 20%


Short-term capital gains are taxed as ordinary income according tofederal income tax brackets.

Depreciation Recapture

The IRS allows you to depreciate the value of a rental property over a 27.5 year period to account for wear and tear that the property might go through. Note that the land itself is not depreciable. The depreciated amount can then be claimed back against the amount of taxes owed for that year.

When it comes time to sell the property underdepreciation recapture section 1250, the IRS partially reclaims the deducted value of the property.

On top of this, the capital gains made beyond the original cost basis qualify for the favorable long-term gains tax rate (maximum of 20%), but the part related to depreciation is taxed at a maximum tax rate of 25% for 2019. 

For example:

You buy a property for $340,000 with the land worth $65,000 and the property worth $275,000. You make no deductible improvements to the property during the time you own it. After 10 years you decide to sell the property for $500,000.

  • The yearly depreciation deductible works out to be $275,000 / 27.5 = $10,000 x 10 years = $100,000.
  • The adjusted cost basis then is $340,000 - $100,000 = $240,000
  • The capital gains on this property $500,000 - $240,000 = $260,000
  • This is then split into two different taxable portions, the capital gains ($260,000 - $100,000 = $130,000) which is taxed at the favourable long term gain rates and the depreciation ($100,000) which is taxed at a max of 25%. 

This article gives a further detailed explanation of Depreciation Recapture

For further information on how this applies to you consult with a licensed professional.

Ways of avoiding a capital gains tax hit

Long term vs. Short term capital gains rates

The long-term capital gain or loss amount is determined by the difference in value between the sale price and the purchase price. This figure is either the net profit or loss that the investor experienced when selling the asset. Short-term capital gains or losses are determined by the net profit or loss an investor experienced when selling an asset that was owned for less than 12 months. The Internal Revenue Service (IRS) assigns a lower tax rate to long-term capital gains than short-term capital gains.

A taxpayer will need to report the total of their capital gains earned for the year when they file their annual tax returns because the IRS will treat these short-term capital gains earnings as taxable income. Long-term capital gains are taxed at a lower rate, which as of 2019 ranged from 0 to 20 percent, depending on the tax bracket that the taxpayer is in.

When it comes to capital gains losses, both short-term and long-term losses are treated the same. Taxpayers can claim these losses against any long-term gains they may have experienced during the filing period.

capital gains tax

1031 exchange

Real estate investors are often looking for the next investment and unless you are looking to cash out you can put off paying capital gains taxes thanks toSection 1031

A 1032 exchange lets you sell your rental property, purchase a “like-kind” property and defer paying taxes at the time the exchange is made. You can execute 1031 exchanges as many times as you want, but when you eventually take a profit, taxes will be due.

The simplest way to defer taxes is to swap one property for another. A more complicated strategy called a deferred exchange lets you sell a property and then acquire one or more other like-kind replacement properties. 

The term like-kind means in this context another ental property. You cannot, for example, 1031 exchange a second home. The main stipulation is that the property must be used for rental purposes and generate income.

You get 45 days from the date of the sale to identify potential replacement properties and you must close on the replacement property (or properties) within 180 days. If yourtax return is due before that 180-day period, you must close sooner. 

Here’sa good article that goes into more detail about what a 1031 exchange is and how to pull one off.

Turn the property into your primary residence

As we mentioned at the beginning of this article when you sell your primary residence the first$250,000 ($500,000 if you’re married) of profit made through capital gains is tax free. Which is why some people convert rental properties into their primary residences.

To qualify as a primary residence you must have:

  • Owned the property for at least 5 years;
  • Lived in it for at least 2 of those years.

A further note is that the amount of your deduction depends on how long the property was used for rental versus as a primary residence.

For example, you buy a property and live in it for two years and rent it out for three. After five years of ownership, you sell. You would then have to pay capital gains taxes on 3/5ths of the profit generated from the sale of the property as you lived in it for 2/5ths of the time.

Offest with losses

A final way you can reduce your taxable income when you sell a property is to offset losses from another area of your investments against the profits of the sale of your property.

For example, you make $100,000 of capital gains on the sale of your property. However, you lose $20,000 in stocks. You could offset this loss against your profits so that your taxable capital gains is only $80,000.

Conclusion

Capital gains tax on the sale of a property can take a hefty chunk out of your profits, especially if you are unprepared. However, there are several ways, detailed above, to minimize this tax.

Everyone’s scenario is different, so it’s always worth discussing your options with your accountant to make sure you take the appropriate action.


Thanks for reading and we hope you found this blog interesting! However, do note that the purposes of this article is for general information. We are not licensed financial or legal professionals and as such nothing in this article should be understood to be financial or legal advice. If you are in need of financial or legal assistance please seek the help of a competent professional.

Ben Luxon

"Ben is a co-founder, author and real estate enthusiast. His interest in all things entrepreneurial has led him to work with real estate professionals all over the world, distilling their knowledge into articles and Ebooks. His love of travelling has taken him to over 10 countries in the last year, where he has sampled the craft beer of them all."



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