What Are Capital Gains On Rental Property?

What are capital gains on rental property?

Capital gains on rental property are the profit you make when you sell the property for more than its adjusted basis. Your adjusted basis starts with the original purchase price, increases with the cost of certain improvements, and decreases with deductions such as depreciation claimed while renting it out. The taxable gain is generally the amount you receive from the sale minus this adjusted basis.

For example, say you purchased a rental property for $200,000. Over the years, you spent $30,000 on qualifying improvements, such as a new roof, and claimed $10,000 in depreciation deductions. These adjustments bring your property’s adjusted basis to $220,000. If you sell the property for $300,000, your taxable gain would generally be $80,000 before subtracting any eligible selling expenses.

There are two main categories of capital gains:

Short-term capital gains

Short-term capital gains apply when you sell a rental property you’ve owned for one year or less. These gains are taxed as ordinary income, which means they’re subject to the same tax rate as your regular earnings.

Depending on your income bracket, this could result in a higher tax rate than if you held the property longer. To see how your income affects the tax rate you’ll pay, refer to the federal income tax brackets below:

Long-term capital gains

Long-term capital gains apply when you sell a rental property after owning it for more than one year. These gains usually come with lower tax rates than short-term gains.

The rate you’ll pay depends on your taxable income and filing status, so it’s worth understanding how these taxes work when planning your sale. The table below shows the long-term capital gains tax brackets and the income limits for each rate based on your filing status.

If you’re curious about how much profit you might earn from selling your rental property, check out HomeLight’s Net Proceeds Calculator.

How to calculate capital gains on rental property

To figure out how much capital gains tax you might owe on your rental property, you’ll need to know a few things, including what you paid for the property, its adjusted basis, how much you sold it for, and any deductions you can claim. Here’s a simple breakdown of how to calculate capital gains on rental property:

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.

How to avoid capital gains tax on rental property

Although selling a rental property can leave you with a solid profit, taxes can take a bite out of what you walk away with. The good news is that you may have a few options to keep more of that money in your pocket. From timing your sale to exploring tax breaks, knowing your options ahead of time can help you avoid or reduce capital gains taxes.

Make the home your primary residence

If you move into your rental property and make it your primary home, you may qualify for the home sale tax exclusion. To get the full benefit, you generally need to own the property and use it as your main home for at least two of the five years before selling. This lets you exclude up to $250,000 in capital gains if you’re single or $500,000 if you’re married and filing jointly.

However, there are a few catches. Any depreciation claimed while the property was rented out generally remains taxable. Also, rental periods after 2008, before converting the property into your primary residence, may count as non-qualified use and reduce the amount of gain you can exclude. Certain exceptions apply, so check the IRS rules.

Use a 1031 exchange (like-kind)

A 1031 exchange lets you defer capital gains taxes when you sell a rental property and reinvest the proceeds into another qualifying investment property. The replacement property must be of like-kind, meaning both properties must be held for investment or business use, not personal use.

You’ll also need to identify a replacement property within 45 days of selling your original property and complete the purchase within 180 days. One important catch: You generally can’t handle the sale proceeds yourself. You’ll need a qualified intermediary to hold the money and facilitate the exchange while you meet the IRS requirements.

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.

How to lower your capital gains tax liability

If you can’t avoid capital gains taxes completely, there are still ways to keep your tax bill down. You can do this by claiming eligible deductions and adding qualifying expenses to your property’s cost basis, which can help reduce your taxable profit when you sell.

Claim qualified expense deductions

Keeping track of what you spend on your rental property can help lower your tax bill, but different expenses serve different purposes. Costs like mortgage interest, insurance, maintenance, and eviction expenses may be deductible from your rental income. Meanwhile, expenses directly related to selling the property, such as agent commissions and certain closing costs, can reduce your taxable profit from the sale. Knowing which expenses fall into each category can help you avoid missing out on potential tax savings.

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.

Apply tax-loss harvesting

If you have stocks or other investments that have lost value, consider selling them to offset some of the capital gains from your rental property sale. This strategy, known as tax-loss harvesting, can help reduce your overall capital gains tax.

However, keep in mind that capital losses generally offset capital gains, not ordinary income. So, while this approach can lower the taxes on your property’s capital gains, it won’t necessarily reduce the taxes you owe on depreciation recapture, which is typically taxed separately as ordinary income.

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 IRA or 401(k) to buy and sell rental properties may help you defer or avoid capital gains taxes. Depending on the account type, profits from property sales can grow tax-deferred or even tax-free. But there are some strict rules to follow.

For example, you generally can’t use the property for personal benefit or enter into certain transactions with family members or other disqualified people. Some rental property income may also trigger unrelated business taxable income (UBTI), which could mean additional taxes. Before going this route, talk to a tax professional who understands self-directed retirement accounts so you know what you’re getting into.

Gift the home into a charitable remainder trust

A charitable remainder trust (CRT) lets you transfer your rental property to a trust while receiving income from it over a set period or for the rest of your life. The remaining assets go to a charity after the trust term ends or you pass away.

In certain circumstances, the trust can sell the property without triggering an immediate capital gains tax bill for you. You may also qualify for a charitable tax deduction. However, there’s a catch: distributions you receive from the trust can still carry taxable income, depending on the type of income the trust earns.

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: Consult a CPA or tax advisor to make sure you’re properly complying with IRS rules and taking 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.

What's Your Rental Property Worth Now?

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Ready to sell your rental property?

Selling a rental property can leave you with a solid profit, but don’t forget to factor in the capital gains taxes you may owe. The good news is that understanding how these taxes work can help you plan and find ways to reduce your tax bill. From tracking your property improvements to taking advantage of eligible deductions and tax strategies, a little preparation can go a long way.

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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Editor’s note: This post is for educational purposes only and should not be construed as professional tax advice. HomeLight encourages you to contact your own advisor.