Given how strong real estate markets have been over the last year, many Landlords have considered selling their rental property to take advantage of the high selling prices across much of the country. Knowing how to avoid capital gains can help hold earnings from the increased profits for real estate investors and keep them from going to capital gains taxes. This is especially true for Landlords that have held properties for a long time and have seen significant appreciation.
That said, there are ways for Landlords to avoid or reduce their tax exposure. So, before making a decision about whether or not to sell a property, it’s important to understand how the capital gains tax works and how your tax liability can be reduced or deferred.
The Basics of Capital Gains
Capital assets – for example, stocks, bonds, or real estate – are subject to the capital gains tax. This means that investors have to pay taxes on any gains made from the sale of capital assets. Capital assets owned for less than a year are subject to a short-term capital gains tax, and those held for 12 months or longer are subject to a long-term capital gains tax.
As you’d imagine, the long-term tax rate is substantially lower. The tax rate depends on your tax bracket but is 15 or 20% for most taxpayers. Here’s an overview of the capital gains tax rate for 2022:
- For individuals that are single, the thresholds are: 0% for income up to $41,675; 15% for income of $41,675 – $459,750; and 20% for income over $459,750
- For individuals that are married and filing separately, the thresholds are: 0% for income up to $41,675; 15% for income between $41 to 258,600, and 20% for income over $258,600
- For married people filing jointly, the thresholds are: 0% for income up to $83,350; 15% for income between $83,350 and $517,200, and 20% for income over $517,200
For the sale of a property that has seen years of appreciation, this can be a high number. As a result, it’s important to understand ways that you can avoid, defer, or reduce this tax. Here are 4 options to consider.
Loss harvesting, or tax-loss harvesting, is a process where you offset capital gains with capital losses. This is a way of reducing tax exposure by combining gains and losses in the same tax year. Your losses will offset the gain and you can reduce or avoid a capital gains tax. This process is most often used with stocks but is becoming increasingly popular with real estate sales.
Here’s an example of how this works. If you’re preparing to sell a rental property and have unrealized losses in your stock portfolio, you could sell some stocks at a loss to offset the gain. Let’s assume you have $100,000 in capital gains from a real estate sale and $125,000 in unrealized losses in your stock portfolio. If you sold some stocks for a loss of $100,000 in the same year as the real estate transaction, the loss would offset the gains and you would have no capital gains tax exposure.
A like-kind exchange, often known as a 1031 exchange, is a way that investors can defer their capital gains tax by using the proceeds from the sale of real estate to purchase another rental property. A 1031 exchange requires the purchase of like-kind property, but this term is broadly defined and simply means that you have to purchase another incoming-producing rental unit.
This type of exchange can be ideal for investors that want to purchase real estate with a higher return, those wanting to consolidate investments, or investors that have fully depreciated a rental property. It’s important to note that a 1031 exchange does not let you avoid paying the capital gains tax but instead lets you defer it until the sale of your replacement property.
A 1031 exchange can be complicated, so it’s important to work with professionals to make sure that you get all of the benefits of this type of transaction. The timing is particularly important, as you have to identify the replacement property within 45 days of the initial sale and you have to close on the replacement property within 180 days of the initial sale.
Another way that investors can reduce their tax exposure is by living in their rental property prior to selling it. If you make your rental property your primary residence you can exclude up to $250,000 of capital gains for taxpayers that are single and up to $500,000 if filing jointly.
To qualify for this exclusion, you must have owned the property for at least five years and lived in it for two out of the five years immediately preceding the sale. The two years do not have to be consecutive. The amount you are able to exclude depends on a number of factors, including how long you’ve owned the property and how long it was your primary residence.
It’s a good idea to consult with a tax professional to determine how much you could exclude, but this is one strategy that investors can consider avoiding the capital gains tax.
Investors that own their rental property free and clear can also consider offering seller carryback. In this type of transaction, the seller carries a mortgage on the property and the buyer makes monthly payments to the seller. This means that as the seller, you’ll only pay taxes on a portion of the monthly payment from the buyer. Plus, you’d make some additional interest income. The downside, of course, is that you don’t have the cash to invest in other capital assets.
Everything You Need for All Phases of the Landlord Lifecycle
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