How to Prevent a Tax Hit When Selling a Rental Property

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Learn three ways to reduce your capital gains exposure

Investing in rental properties can supply investors with steady revenue streams that cover the mortgage while supplying some extra profits each month. When such properties are ultimately sold, investors stand to enjoy substantial windfalls. But these selling events can trigger significant long-term capital gains tax liabilities.

Case in point: That tax rate is 15% if you’re married filing jointly with taxable income between $83,350 and $517,200. If your taxable income is $517,200 or more, the capital gains rate increases to 20%. 

For a married couple filing jointly with a taxable income of $280,000 and capital gains of $100,000, taxes on the profits from the sale of a rental property would amount to $15,000. Fortunately, there are ways of minimizing this capital gains tax bite. This article explains three of the most effective methods.

KEY TAKEAWAYS

Offset Gains With Losses

• What it is: Tax-loss harvesting
• Who it’s for: Anyone with capital losses in a given tax year
• What you get: The ability to subtract those losses from the capital gains realized from a rental property sale

Tax-loss harvesting describes the process of reducing tax exposure when selling a rental property by pairing the gains from the sale with the loss from another investment. This can be a tax planning strategy if an investor is holding an investment that has lost value (an unrealized loss) and decides to sell the asset at a loss in the same year as the gain on rental property sale (a realized loss). Although this tax-minimizing tactic primarily serves to offset gains from stock investments, more folks are now applying it to rental real estate property sales.

For example, assume an investor made $50,000 from the sale of a rental apartment in the current year. They also have an unrealized loss of $75,000 in the stock market. The investor can choose to sell off a portion of their stocks to realize a $50,000 loss in order to fully offset the $50,000 in capital gains.

Take Advantage of Section 1031 of the Tax Code

• What it is: IRS Section 1031 “like-kind” exchange
• Who it’s for: Anyone who can reinvest the proceeds of rental property sales in new real estate
• What you get: The ability to defer some or all taxes on the capital gain

Real estate investors can defer paying capital gains taxes using Section 1031 of the tax code, which lets them sell a rental property while purchasing a like-kind property and pay taxes only after the exchange is made. Legally speaking, the term like-kind is broadly defined. An investor need not swap out one condo for another or trade one business for another. As long as both properties in question are income-generating rental units, they’re fair game.

But timing is key with this method because investors have just 45 days from the date of a property sale to identify potential replacement properties, which they must formally close on within 180 days. And if a tax return is due (with extensions) before those 180 days, investors must close even sooner. Those who miss the deadline must pay full capital gains taxes on the sale of the original rental property.