What You Need to Know About Capital Gains Tax on a Real Estate Investment Property

What are Capital Gains Taxes?

Simply put, capital gains are the net profit when someone sells something they own. To calculate your capital gains in real estate, you would subtract the amount you paid for the property and the cost of any improvements you put into the property from the final selling price. The number you are left with is your capital gain.

There are two types of capital gains. It’s important to understand the difference between the two, as they are treated differently during tax time. 

  • Short-Term Capital Gains

If you only had your investment property for one year or less before selling, then you have short-term capital gains. When it comes to your taxes, short-term gains are treated the same as your income from your job. That means they will be taxed anywhere between 10%-37%, depending on your tax bracket. Short-term gains most often happen with flipped houses, as investors try to get in and out of these investments quickly. 

  • Long-Term Capital Gains

Long-term capital gains is when you own an investment property for more than one year. Investment properties that have long-term capital gains are taxed at a lower rate compared to short-term gains. The rate can vary between 0%-20%, depending on your income and filing status. 

How Much Capital Gains Tax Do You Pay on an Investment Property?

Finding out how much tax you will pay on your investment property is dependent on many different factors. To calculate, first begin adding up the price you initially purchased the property for (including closing costs) and the cost of any improvements you have made over the years. It’s important to note that improvements are classified as items that will increase the property value or extend its life. For example, a kitchen renovation would be considered an improvement, while painting the living room would not. 

To find out your capital gains, subtract the number above from the price that you are selling the investment property. Before you are hit with your capital gains tax, you will first be paying your depreciation recapture tax. This is the money you owe from depreciating your rental property over a period to help pay less taxes for that year. Determining the tax rate you will pay is dependent on your current financial status.

2020 Long-Term Capital Gains Tax Bracket

  • Single:
    • 0%: income below $40,000
    • 15%: income between $40,001 and $441,500
    • 20%: income more than $441,500
  • Married filing jointly:
    • 0%: combined income of $80,000 or less
    • 15%: combined income between $80,001 and $496,600
    • 20%: combined income more than $496,600

How to Avoid Capital Gains Taxes

Capital gains taxes can take a significant portion of your profits, but there are ways to reduce or avoid these taxes altogether. Some common strategies include:

  • Turn your investment property into your primary residence

Primary residences do not have to pay taxes on their entire gain. IRS Section 121 lets you exclude up to $250,000 of capital gains if you are a single filer and $500,000 of capital gains if you’re married and filing jointly. For your investment property to be considered your primary residence, you must live in the house for at least two of the five years immediately preceding the sale. 

  • Tax-Loss harvesting

Tax-loss harvesting is when you pair the capital gains you received on your real estate investment with losses from your other investments. For example, if you have $60,000 in capital gains but $50,000 in losses from a bad stock investment, your capital gains would only be $10,000.

  • Section 1031 exchange

One of the most popular techniques to avoid capital gains taxes is the 1031 exchange. This is a tax code that allows you to reinvest the profit from the sale of your investment property into the purchase of another “like-kind” property. “Like-kind” properties must be a real property that you have held for productive use in a trade for business or for an investment. This helps you avoid both the capital gains and depreciation recapture taxes. There are strict time limits with 1031 exchanges, and we recommend speaking to an accountant to ensure you know all of the rules and regulations. 

Top Accountants in Morris County, New Jersey

If you are selling your first investment property, it is best to speak with an accountant to ensure you are filing correctly and make back as much of your gains as you can. Here at RMG, we can ensure that your taxes are filed properly and you avoid as much capital gains taxes as possible. Our ultimate goal is to provide value-added service to all of our clients. We utilize advanced methods and technology to streamline our processes in order to provide information and trustworthy financial support in a timely manner. For more information, please contact us today.