What Are Capital Gains On Rental Property?

How to calculate capital gains on rental property

Calculating capital gains on your rental property starts with understanding a few key components: your property’s purchase price, adjusted basis, selling price, and any eligible deductions. Here’s a simplified guide to help you break it down:

1. Determine the selling price: This is the amount you sold the property for, minus any selling expenses like agent commissions or closing costs.

2. Calculate your adjusted basis: Start with the purchase price of your property. Add the cost of major improvements and subtract depreciation you’ve claimed over the years. (More on depreciation later in the post.)

3. Subtract the adjusted basis from the selling price: The result is your taxable capital gain.

Example calculation

Let’s say you purchased a rental property for $200,000 and sold it for $300,000 after 10 years. During that time, you made $30,000 in improvements and claimed $50,000 in depreciation. Selling expenses totaled $15,000.

1. Selling price: $300,000 – $15,000 (selling expenses) = $285,000

2. Adjusted basis: $200,000 (purchase price) + $30,000 (improvements) – $50,000 (depreciation) = $180,000

3. Capital gain: $285,000 – $180,000 = $105,000

In this case, your taxable capital gain is $105,000. Depending on whether your property sale qualifies as a short- or long-term gain, your tax rate will vary.

How to avoid capital gains tax on rental property

Avoiding capital gains tax on a rental property may seem challenging, but there are several strategies that could help you reduce or defer your tax liability. These methods often require careful planning and adherence to specific IRS rules.

Make the home your primary residence

If you convert your rental property into your primary residence, you may qualify for the home sale exclusion. This allows you to exclude up to $250,000 of capital gains if you’re single, or $500,000 if you’re married and filing jointly. To qualify, you must have lived in the property for at least two out of the five years before selling.

Use a 1031 exchange (like-kind)

A 1031 exchange allows you to defer paying capital gains taxes by reinvesting the proceeds from the sale of your rental property into another like-kind property. The new property must meet strict criteria, and the exchange must follow specific timelines to remain eligible for tax deferral.

Apply tax-loss harvesting

If you have investments that are currently at a loss, you can sell those assets to offset the gains from your rental property sale. This strategy, known as tax-loss harvesting, can reduce your taxable income for the year.

Keep the property longer

By holding onto your rental property for more than a year, your profits will qualify as long-term capital gains, which are taxed at lower rates than short-term gains. In some cases, retaining the property can also allow market conditions to improve, potentially increasing your overall return.

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How to lower your capital gains tax liability

If avoiding capital gains tax altogether isn’t an option, there are several ways to reduce the amount you owe. These strategies focus on maximizing deductions and increasing the cost basis of your property.

Deduct the property’s depreciation

The IRS accepts the fact that a rental property can lose some of its value every year, usually around 3.636% in the U.S. This principle of depreciation allows you to deduct the cost of a rental home over a period of time. Such losses can be subtracted from your taxable income every year you own the property, up to 27.5 years. Claiming depreciation can lower your tax liability and might even move you into a lower tax bracket.

Claim qualified expense deductions

Expenses like mortgage interest, maintenance, insurance, and necessary professional services can often be deducted from your taxable income. This can even include eviction-related expenses. These qualified deductions can reduce the net gain from your property sale, helping to lower your tax bill.

Make improvements to increase the home’s basis

The basis of your property is the original purchase price plus the cost of improvements. By investing in capital improvements — such as a new roof, updated plumbing, or major renovations — you can increase your property’s basis. A higher basis reduces the taxable profit when you sell, lowering your capital gains tax liability.

Less common ways to avoid capital gains taxes on a rental property

For property owners looking to get creative, here are two less conventional ways to minimize or avoid capital gains taxes:

Buy and sell through a retirement account

Using a self-directed retirement account to buy and sell rental properties can help you defer or avoid capital gains taxes. When properties are bought and sold within accounts like an IRA or 401(k), gains are either tax-deferred or tax-free, depending on the account type. However, strict rules apply, so consulting a financial advisor is crucial.

Gift the home into a charitable remainder trust

A charitable remainder trust (CRT) allows you to transfer ownership of your rental property to the trust. You can receive income from the trust during your lifetime, and the remaining assets are donated to a charity after you pass away. This strategy avoids immediate capital gains taxes and provides significant tax benefits, including a charitable deduction.

Tips when selling a rental property

If you decide to sell your rental property, these tips can help streamline the process and maximize your profit:

• Understand the tax implications: Know how capital gains taxes will affect your bottom line.
• Plan the timing of the sale: Selling after holding the property for more than a year qualifies you for lower long-term capital gains rates.
• Document expenses thoroughly: Keep detailed records of repairs, maintenance, and improvements to maximize deductions.
• Know the rules if you have tenants: If your property has tenants, carefully review your legal and contractual requirements before you sell the house.
• Work with a tax professional: Consulting a CPA or tax advisor ensures you follow IRS rules and take advantage of tax-saving strategies.
• Partner with an expert agent: An experienced real estate agent can help you price and market your property for a smooth transaction.

Ready to sell your rental property?

If you’re thinking about selling your rental property, you don’t have to navigate the process alone. With HomeLight’s Agent Match platform, you can connect with a top-performing real estate agent who knows your local market and can guide you every step of the way.

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