capital gains tax for rental property

How to Avoid Capital Gains Tax When Selling a Rental Property

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Selling a rental is not the same as selling a primary residence because the IRS sees it as a business investment. When you sell a rental property, the profit (or gain) is reported as a taxable sale. Here’s what you need to know about capital gains and how to avoid them.

How to Calculate Capital Gains Tax?

There are two kinds of capital taxes, depending on how long you held the rental in your portfolio. The income from the sale is taxed based on a long-term or short-term capital gains rate. What does that mean? 

  • A short-term rate applies if you held onto the property for less than a year. If that is the case, the tax rate is the same as your normal income tax rate. The maximum you can pay is 37%.
  • The long-term rate applies if you held onto the property for more than a year. These tax rates are 0%, 15%, or 20%, applied according to income and filing status.

Avoid (or Lessen) Capital Gains Tax on a Rental Property

While there is no guarantee you will not pay any capital gains tax, you may be able to lessen its impact on your profit.

1031 Exchange

With a 1031 deferred exchange, also known as a 1031 like-kind exchange, you can defer capital gains tax if you invest the proceeds in a new property or portfolio of equal or higher value. Special rules apply:

  • You cannot use the proceeds from the sale of a rental property to buy a primary residence or vacation house. The new property must be used for rental income.
  • You have 45 days from the sale to find a new property, and you must close within 180 days. Check the due date for your tax return to make sure it is not due sooner.
  • Any cash left over after the purchase of the new property is taxable.

The 1031 exchange can be a complex process. A CPA or company that has experience with these transactions can help ensure that you meet the requirements of the 1031 tax code.

Live in the Rental to Turn It into a Primary Residence

There are different tax requirements for the sale of a principal residence. The first $250,000 earned is excluded from taxable income, as long as the seller lived in the residence for at least 2 of the 5 years of ownership.

Section 121 of the Internal Revenue Code allows you to reduce the capital gains by:

  • Making the second house the primary residence for 2 years before selling.
  • The 2 years of residence can occur anytime during the 5 years of ownership, prior to selling. Those 2 years do not have to be consecutive.
  • If the property was part of a previous 1031 exchange, you must hold it for a minimum of 5 years to be eligible for the gain exclusion.

However, turning your rental into a residence may not help reduce the tax bill if you substantially depreciated your property or owned it mostly as a rental, since you can only prorate the capital gains exclusion based on years of qualified (residential) use.

Offset Gains with Capital Losses

Let’s say you sell your rental property for more than you paid for it, but your portfolio takes a hit. You can offset your loss with the capital gained from the property sale.

You can also deduct normal business operating expenses and non-cash depreciation expenses to minimize the amount of taxable income.

The key is to deduct as much as possible to offset the gain so it breaks even or as close as possible. Ask your CPA for more details on this option to make sure you can take advantage of it.

Choose an Installment Sale

An installment sale, also known as seller financing, is a great way to reduce taxes by spreading out the payments over a longer period of time. 

It makes it easier to offset gains since it results in a lower tax than the tax on a lump-sum gain. Usually, installment sales are structured, and how long you hold onto the property will determine how it’s taxed: long-term or short-term.

For further details on the advantages and disadvantages of an installment sale, read our article on Lump-Sum Sale vs. Seller Financing.

What Happens If I Sell to an Investor?

Selling to an investor has its benefits, most of which do not come by selling to a traditional buyer:

  • Sell the property “as-is” – damaged, neglected, vacant, or with bad tenants.
  • No appraisal, inspection, or other contingencies are attached.
  • You choose the closing date, in several months, 15 days or less.
  • Decide if you want cash or an installment sale!

You may have specific questions about selling your rental property to an investor, and we have the answers. We can also match you with investors in your area who are ready to buy your property, no matter its condition or situation.

solid offers What is an investor example of fix and flip

What is a Real Estate Investor?

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You have probably seen television shows and advertisements, but what exactly is a real estate investor?

The better question is not what, but who is a real estate investor. Although an investor may represent a corporation, most of the ‘House Buying’ companies you might come across are small businesses owned by a local hard-working entrepreneur. Like any small business owner, they intend to provide for their family and positively contribute to the community in which they live.

What Exactly Do Investors Do?

As you have likely surmised, real estate investors work with the homeowner directly to purchase their property. This direct connection eliminates the need to place your house on the market, make repairs, or hire a real estate agent.

Although there are several different types of real estate investors, which we will discuss shortly, they all tend to offer the homeowner the same incentives: a fast cash offer, an easy escrow, an ‘As-Is’ purchase, and a closing timeline that suits the seller.

How Does It Work?

Every legitimate investor aims to create a win-win situation with the homeowner. For the investor, this most often translates into a reduced purchase price on the property. For the property owner, this could mean:

  • Peace of mind of knowing their property is sold,
  • Not having to make repairs,
  • Being able to avoid caravans of traditional buyers walk through their house,
  • Not having to worry about a bank or lender as the reason their property falls out of escrow,
  • Not paying 5% to 6% of the house pricing to an agent,
  • And, unlike with a traditional sale, the owner can move on the date most convenient for them (be it in a week or a year) without having to worry about the buyer backing out.

Most sellers agree that the slightly higher price they may have gotten for their house on the open market is more than compensated for by the ease and stress-free experience of selling to a professional investor. Not all investors have the same end goal for your property; however, it is worth knowing the differences.

The Two Primary Types of Investor You are Likely to Meet

  • Fix and Flip… aka Flippers

Thanks to popular home-improvement TV shows, the Flipper is probably the best-known type of investor. These investors, who are often contractors or work closely with one, look for houses that need some TLC or have untapped potential. By remodeling or renovating, Flippers can raise the property’s value and (hopefully) sell for a profit. 

Despite what is so often portrayed on television, fixing and flipping a house, as a rule, is stressful rather than glamorous. Even with the most careful planning, construction costs always come in over budget. Issues arise with city permits and inspectors, and the renovation takes far longer than planned due to unforeseen complications. The housing market may dip. And every Flipper’s worst nightmare, the house sells for far less than projected. Meaning that the investor takes a financial loss of thousands to hundreds of thousands of dollars. For these reasons, flipping is a high-risk endeavor that is not for the faint of heart. 

  • The Buy and Hold… aka Rental Owners

Buy and Hold investors, similar to Flippers, often purchase properties in need of renovation. But rather than fixing the property to sell it, these investors renovate the property to turn it into a rental. This is a long-term investment technique since each property requires years of steady rent before the investor makes their money. And, as with trying to fix and flip a home, there is never any guarantee of success.

As any homeowner knows, a house requires constant upkeep and maintenance. Even with proper care, things go wrong. The furnace breaks, the bathtub overflows and damages the flooring and subflooring, the dishwasher stops working, and so on. Such expenses are part of owning property but add in tenants who fail to pay rent and/or intentionally damage the property, and the investor can kiss their revenue goodbye. Nothing is risk-free, and the investor knows this going in.

Finding the Right Investor

95% of real estate investors are local hard-working professionals who will take care of you every step of the way. As with every industry, however, there are going to be a few bad apples. These bad apples typically represent 5% or less of the industry, but you still have to watch out for them. And with so many investors out there, it can be hard to know who to trust. 

This is why SolidOffers.com works exclusively with a trusted network of real estate investors located throughout the country. These investors come with a proven track record and are thoroughly vetted to ensure they are experienced, professional, and the right fit for you. If selling your house through a local investor is an option you have considered, or would like to explore a little further, then reach out, or use the platform provided by SolidOffers, to find a trusted investor in your area.