If you own an investment property, or are looking into investment properties, you need to keep reading. Understanding the finances and tax situation behind real estate investing is crucial for anyone who’s looking to make some money renting out properties.
One of the most misunderstood terms in taxes, we find that a lot of our clients don’t understand what capital gains are. Even more notable, they don’t understand what the capital gains tax is.
To learn more about the capital gains tax on investment property, read on.
What Are Capital Gains Taxes?
The term “capital gains” refers to the money gained on something that you’re going to buy and then sell. In terms of real estate, you’ll have capital gains if you sell a property for more than you originally bought it for.
There are two kinds of capital gains: short-term capital gains and long-term capital gains. Each kind is important to distinguish from the other when it comes to taxes.
Short-Term Capital Gains
If someone has short-term capital gains, this means that they owned the property for less than one year. Because they are short-term, they are taxed as regular income. This means that you’d pay the same amount of tax that you’d pay if the income were coming from a normal, nine-to-five job.
You can view the 2021 tax brackets here. The government will tax you according to those brackets if you’ve owned and sold a short-term rental.
Those of you who flip houses are likely to get taxes based on this normal income. This is because house flippers tend to only have a property for a few months at a time.
Long-Term Capital Gains
However, if you hold a property for more than a year, it is considered a long-term capital gain. These profits are taxed at a lower rate to encourage long-term property ownership.
You can see the capital gains tax rates here. Any long-term properties that you own and sell will be taxed according to these.
Substantial Capital Gains (Short-Term or Long-Term)
If you’re making a substantial amount of money from your properties (whether long-term or short-term), you may be taxed at a higher rate. To be exact, the government may tax you an extra 3.8% net investment income tax.
If any of the following situations apply to you, you may owe this extra amount:
- You are married, filing jointly, and made more than $250,000 from capital gains during the tax year in question
- You are married, filing separately, and made more than $125,000 from capital gains during the tax year in question
- You are single, filing independently, and made more than $200,000 from capital gains during the tax year in question
- You are the head of the household and made more than $200,000 from capital gains during the tax year in question
- You are a qualifying widower, have dependent children, and made more than $250,000 from capital gains during the tax year in question
Speak to your personal certified public accountant (CPA) for guidance regarding these capital gains taxes.
Speaking of the capital gains tax rate, let’s dive into what the tax is and why it even exists.
What Is the Capital Gains Tax on Investment Property?
You are only required to pay capital gains taxes if you sell the property that you own. You must also make a profit off of the property.
This means that you are not to pay the capital gains tax if you still own the property or if you lost money on the sale of a property.
The capital gains tax is due when the property is officially sold. You don’t get to wait until the end of the year or even the end of the quarter.
Once you hand over the property title, you owe the IRS your taxes on investment properties.
How Do You Calculate the Capital Gains Tax?
Calculating the investment property capital gains tax isn’t as easy as you may hope that it is. Of course, the IRS never makes taxes easy.
Don’t subtract the price that you bought the house for from the price that you sold the house for. This isn’t considered the gain on the property, although it makes sense that way to most people who try to do their taxes.
Instead, you should start by subtracting the cost basis of the property from the net proceeds you made from the sale. By calculating it this way, you’re taking into account the several different factors that could affect the value of the property.
Don’t worry. This actually makes your tax burden less than what it would be if you calculated the capital gains using the wrong (yet popular) method.
First, you should know how much you paid for the property. If you’re a great organizer, you likely have the documents stashed somewhere.
However, if you aren’t sure where they are, you may need to consult your accountant, your mortgage, your bank statements, or some other source that holds the original cost.
Once you have this amount, you need to add the following things to it:
- Legal costs related to the purchase of the property, including legal fees, appraisal fees, and closing costs
- Costs related to improvements you made on the property while you owned it
Hopefully, you’ve been keeping receipts and records throughout your ownership of the property. Keeping up with receipts is especially important if you’re managing a rental property.
We should note that the ‘improvements’ that you’re counting towards the value of the home must have added value to the property. This could be by changing the use of the property or by making the property last longer.
Any of the following improvements could count improvements towards the calculation of the cost basis:
- A new roof
- The addition of a new room
- A kitchen remodel
- The installment of a new tub
- The addition of a porch
If you’re completing projects that are purely for the cosmetics or regular maintenance of the house, these do not count towards the calculation of the cost basis. The following project should not count towards your calculation:
- A new coat of paint
- A new porch stain
- Getting the gutters cleaned
- Changing the exterior brick
If you’re unsure about an improvement that you made to your property, consult your CPA. They should be able to sift through your receipts and determine what should go towards your calculations.
When you officially sell the property, you don’t actually make all of the money that comes with the sale of the property. There are various costs associated with the sale that can take away from the amount of money that you actually make:
- The real estate agent’s commission
- Home staging
- House cleaning
- Transfer fees
- Lawyer fees
Calculate all of the fees that came with the sale of the property and subtract these from the official sale price of the property. This gives you your net sales proceeds.
Once you’ve calculated your cost basis and your net proceeds, you can calculate the capital gains that you made on the property.
Subtract the cost basis value that you calculated from the net proceeds value that you calculated. Then, determine whether you had a capital gain or a capital loss.
If subtracting the cost basis from the net proceeds gives you a positive number, you have a capital gain. However, if you get a negative number after you subtract the values from one another, you have a capital loss.
Assuming that you have a capital gain, you would compare the final number that you calculated and compare it to the capital gains tax brackets. Based on your filing status and the number that you calculated, you’ll be able to find your tax rate for those gains.
Be sure to double-check whether or not you have to pay the additional 3.8% tax that we mentioned above.
How Do You Lower Capital Gains Tax?
We know that no one likes paying taxes, so we’re here to help you lower the amount of taxes that you have to pay. By lowering your capital gains, you can lower the tax that you have to pay on it.
Let’s look at some strategies for lowering capital gains and the capital gains tax.
1. From Investment Property to Primary Residence
Because of IRS Section 121, you may be able to avoid paying taxes on some of the capital gains if you claim the investment property as a primary residence. According to this section of the tax code, you don’t have to pay taxes on all of the capital gains that you make.
By claiming the investment property as a primary residence, you can exclude up to:
- $250,000 on your capital gains if you’re a single, independent filer
- $500,000 on your capital gains if you’re married and filing jointly
In order to count the property as a primary residence, you have to own and live in the house for at least two of the five years that immediately preceded the sale. Because of this rule, you might want to claim investment properties for the few years prior to the sale of the property.
You could save yourself a lot of money.
2. Harvest Tax-Loss
Another strategy for lowering your capital gains tax is tax-loss harvesting. This involves pairing the gain from the sale with losses that you may have had with other investments.
When the IRS looks at your taxes, they pair all of your gains and losses from the entire year. So, even if you sold your investment property at a profit, you might have had some losses in other investments if you diversify your portfolio.
For example, you might have gained $50,000 in capital gains on your investment property, but you might have lost $30,000 in the stock market. After calculating the difference, you only have $20,000 in capital gains rather than the original $50,000.
We should note that the IRS uses short-term losses to offset short-term gains. In the same way, they use long-term losses to offset long-term gains.
However, if either short-term or long-term losses exceed their complementary gains, you can use the other to offset it.
For example, let’s say that you had a short-term loss of $10,000, but you also had a long-term gain of $20,000. You can put $10,000 of the $20,000 in long-term gain and put that towards the short-term loss of $10,000. This negates your short-term gains and losses while making your long-term gain $10,000.
The same rule applies if you end up having long-term losses that you want to offset with short-term gains.
3. Use the Section 1031 Exchange
Section 1301 allows you to sell an investment property and buy what is referred to as a “like-kind” property to defer paying taxes. This process is referred to as a 1301 Exchange, a like-kind exchange, or a Starker Exchange.
However you refer to it, it’s likely that you’re going to need a Qualified Intermediary (an expert on the exchange) to ensure that you aren’t breaking any rules.
This exchange is a great exception for people who want to sell a property but don’t need to cash-out on the gains. Since you aren’t cashing out, you don’t owe taxes when you sell the property.
If you’re looking to perform this kind of exchange, you need to find a like-kind property. This property is a real estate property that you’ve had for productive use, whether for a business venture or as an investment.
You must identify this property within 45 days after selling the investment property. Plus, you must close on the new property within 180 days of selling the investment property. If these deadlines are not met, you will owe capital gains taxes.
Taxes on Investment Properties: More Financial Assistance
After reading all of this information on the capital gains tax on investment property, we’re sure that you’re excited to get your very own investment property off the ground. Perhaps you’re even ready to sell.
Whatever the case, there is still more you need to know about investing in real estate and the financial burden (and gain) that comes with such a venture.