How to Reduce Capital Gains Tax on Sale of Rental
What is the Capital Gains Tax?
Regarding the sale of his rental property, the homeowner knew that this was going to trigger a tax consequence known as the capital gains tax, and since we were at the same starting point, we talked about why he was facing this tax consequence in the first place and different methods to avoid a tax hit when selling his property. In essence, what the government is doing is applying a tax on your personal investment, which in this case is a rental property that has been owned for longer than 12 months. This makes it a long term investment, which is different from a short term investment taxed at the short term capital gains tax, which is usually at a higher interest rate.
So with the long term capital gains, while you still face the taxes, you are rewarded for your patience with a lower tax rate than the short term capital gains tax rate. The capital gains tax bill amount is determined by taking the sales price and subtracting out the original purchase price.
So new sales price minus purchase price is your capital gains tax probably for most people. The long term capital gains tax rate is 15%. That number applies to anyone who makes between $81,000 and $440,000, give or take, depending on the time that you watch/read this and the most current changes to the tax code. For joint married couples filing, that number usually resides around $495k, and that’s going to get you in the 15% tax rate on long-term capital gains.
So any sale on an investment that’s been held for longer than 12 months, it’s going to be taxed at 15% via this tax bracket, granted that there may be some changes depending on when you watch this and your income levels. As of right now, it’s safe to assume 15%, but check with your CPA obviously before you make any decisions.
When selling a rental property that you’ve held for longer than a year and you’re looking at facing long term capital gains, there are really three options to help you decrease that amount or avoid these taxes altogether depending on what your long term strategy is.
Option 1: Turn Rental into Primary Residence
The first option if you want to avoid long term capital gains rate is to turn your rental property into a primary residence. Depending on your situation, this could be a good option for you. You could move into the property, fix it up while you live there and then make sure that it’s at top dollar condition and sell the property on market for top dollar. The requirements for this is that you have to live in the property for two of the last five years. The hidden benefit is that they don’t have to be in consecutive years and you can use this to sell your property as a primary residence while significantly reducing your tax burden. If possible, this is a great way to decrease or even avoid long term capital gains rates by selling your rental property as a primary residence.
So your first option is to move into the rental as your primary residence which will decrease your tax rate. If you do decide to make your rental property a primary residence in order to decrease your tax hit, then I would definitely recommend consulting your CPA before you make that decision. Anytime that you have taken any depreciation into your house may change what your tax hit is going to be even if you turn into a primary residence, so consult your CPA for your specific needs. But you can go into that meeting knowing that if you turn this into a primary residence, then you have the potential to significantly reduce the tax hit that you’re going to face.
Option 2: 1031 Exchange
The second option to significantly reduce the taxes on your property when you sell a rental property is to do with 1031 Exchange. There have been several discussions around changing this rule or even getting rid of that, but for now, what the 1031 Exchange does is it allows investors to purchase “like” real estate with the profits in order to defer the tax consequence.
A lot of real estate investors will use this as a long term strategy to continue to “level up” almost with the sale of a property. They will then take the proceeds and invest that in another “like” income producing real estate property and they will then defer the taxes and then sell that property in the future again, and you can 1031 again and again into another bigger property.
It is a strategy that works for some real estate investors to defer their capital gains for long term holds that they’ve had. However, there are some requirements to doing a 1031. If you’re doing 1031, the most important thing is to know that you don’t have a lot of time. So you’re going to need to identify a potential “like” property within 45 days of the sale. That’s the first thing, and the second thing to know when doing the 1031 exchange is that you have 180 days in order to close on that second “like” property.
That means that you’re going to be buying another property that’s income producing, so not a personal residence. That’s what they mean by “like” property. As always, check with your CPA for the exact definition to make sure that the property that you are planning on purchasing works for the 1031 exchange, but generally you have 45 days to identify that property and then 180 days to close on that property. Otherwise, the initial long term capital gains from the initial sale will be called due at that time.
Option 3: Sell on Terms
The third option, if you’re looking to decrease your long term capital gains, it is to sell on terms. This is what we talked about with landlords who are looking to offload their property, they can sell their property on terms and maintain their cash flow and decrease their liabilities. They don’t have to worry about repairs or anything like that. They act as the bank, and I’ve never called the bank to let them know that the work that I’m doing here needs any changes. I don’t think they would care and that’s the role that landlords can take when they work with us.
When selling your property on terms you’re able to maintain cash flow, get rid of the headache of tenants, just collect the monthly payments and make interest on your money all while being protected by the property that you’ve owned for years. It’s a great way to lower your tax hit as well because you only get taxed on the money that you collect that year. Since you’re spreading the money out over time, you’re able to collect more money and you’re able to pay less in taxes each year. So it’s a nice advantage that retiring landlords or even landlords who no longer want to be landlords for that specific property or for their whole portfolio can exercise.
If that’s something that interests you, you can reach out to me at 267-984-4765 or fill out the form below and we would love to walk you through what some of the options would look like for you to sell your income producing property on terms to us. We look forward to helping you.