Capital Gains Tax on Real Estate Investment Property (2024)

Real estate investments can be lucrative assets. However, they can also incur capital gains taxes that weaken your profits. Fortunately, you can implement tactics that reduce capital gains taxes so you can keep more of your money. Although the IRS taxes short-term and long-term gains differently, you can combat high tax rates on both. We’ll explain short-term and long-term capital gains and how to keep the associated taxes from costing you an arm and a leg.

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What Are Capital Gains Taxes?

You pay capital gains taxes when you profit from selling assets. You can incur two types of capital gains taxes: short-term and long-term. Short-term capital gains are from selling assets you’ve held for less than a year. On the other hand, long-term capital gains come from selling assets after holding them for a year or more. So, if you sell an investment property, the time you owned it before selling it will determine what kind of capital gains taxes you pay.

How Are Capital Gains Taxed?

The IRS taxes short-term capital gains as standard income, meaning your income tax bracket will determine your tax rate. Income tax brackets are as follows: 10%, 12%, 22%, 24%, 32%, 35%, and 37%. Your income determines your capital gains tax rates.

For example, say you make $85,000 from your day job. You sell an investment property nine months after purchasing it and make a $30,000 profit. The sale results in a short-term capital gain, and your income is $115,000 when you file taxes. In addition, you’re a single filer, putting a portion of your income in the 24% tax bracket.

Conversely, long-term capital gains have different tax rates than short-term gains: 0%, 15%, and 20%, depending on your income level and filing status. For 2023, single filers making up to $44,625 receive the 0% rate. Single filers with income between $44,626 and $492,300 will pay 15%. Finally, single filers with income above $492,300 will pay 20% long-term capital gains taxes. In addition, single filers making $125,000 or more annually will pay a net investment income tax of 3.8% on capital gains from real estate.

A married couple filing 2023 taxes jointly will pay 0% if they earn up to $89,250. The 15% rate applies if the couple earns $89,251 to $553,850. The 20% rate applies if they earn more than $553,850.

In 2024, these numbers increase. You can qualify for the 0% rate if you make up to $47,025 as a single or married filing separately tax filer. Married filing jointly can earn up to $94,050 and head of household can earn $63,000. For single, you can earn up to $518,900 for the 15% tax rate, $583,750 for married filing jointly, $291,850 for married filing separately and $551,350 for head of household.

How to Limit Capital Gains on Real Estate Investment Properties

You can use a variety of strategies to avoid capital gains on real estate properties. Here are some of the most popular ways to do just that.

Use Tax-Deferred Funds

You don’t have to invest in real estate with dollars from your bank account. Instead, you can use your individual retirement account (IRA) or 401(k). Depositing investment profits in your investment account allows your money to grow tax-free. Plus, your IRA contributions can garner you another tax deduction.

Make the Property Your Primary Residence

The Internal Revenue Service (IRS)exempts primary residence sales from capital gains taxes up to $500,000 for married joint filers and $250,000 for single filers. You can also avoid paying taxes on depreciation deductions this way. Using this option means fulfilling the following requirements:

  • Owning the home for two or more of the last five years
  • Living in the home as the primary residence for two or more of the last five years
  • You haven’t taken a primary residence exemption in two years

Tax-Loss Harvesting

Tax-loss harvesting means deliberately selling an asset for a loss to mitigate profits from another asset. Therefore, you can sell a property for less than you bought it, reducing your taxes.

For instance, say you sell one property and make $30,000. You don’t want to pay taxes on this gain, so you sell another property for $25,000 less than what you paid. As a result, you pay taxes on $5,000 of capital gains.

1031 Exchange

The depreciation deduction for rental properties has one major drawback: when you sell a rental property, you owe taxes on the depreciation amount (if you received any). Fortunately, the 1031 exchange allows you to circumvent this rule.

The 1031 exchange means using the income from the sale of an investment property to purchase another investment property of equal or greater value. Then, you don’t have to pay taxes on prior depreciation deductions. This caveat allows you to avoid income taxes on depreciation into perpetuity if you buy another property of equal or greater value.

How to Minimize Your Capital Gains Tax

Even if you can’t altogether avoid capital gains taxes, the following tactics will minimize your capital gains taxes:

Depreciation Deduction

The IRS allows rental property owners to deduct an annual depreciation amount from their income. The deduction comes from the expected lifespan of rental property, which the IRS defines as 27.5 years. As a result, you can calculate your depreciation deduction by dividing your rental property value by 27.5 (commercial real estate uses the lifespan figure of 39 years).

For instance, say you have a $250,000 residential investment property. Dividing this figure by the depreciation deduction lifespan of 27.5 gives you an annual deduction of $9,090.

Itemized Deductions

Generally, you can deduct the costs of managing property, lowering your tax burden. Running your real estate investment business incurs costs such as travel, legal fees, and business equipment. These expenses can add up – but instead of hurting your wallet, they can create a tax benefit.

In addition, you can deduct mortgage interest and the costs of repairing or maintaining a property. Therefore, keeping detailed records and saving every receipt is vital to claiming as many deductions as possible.

Methods to Boost Property Basis

Improving your property gives two financial advantages: the costs of doing so can shrink your capital gains taxes, and the improvements can bolster your property value. Here’s how you can boost property basis:

  • New windows and doors
  • Updated appliances, roofing, and flooring
  • Renovate plumbing, electrical and HVAC systems
  • Paying commissions to real estate agents
  • Expenses for the appraisal, inspection and legal services
  • Closing costs, including title search, escrow and taxes

Bottom Line

Capital gains taxes can curb your profits from real estate investments. Fortunately, multiple deductions and tax strategies can lower your tax burden. For example, you can deduct depreciation and make a home your primary residence before you sell it. In addition, upgrading your home can boost your property basis and lower your capital gains taxes. So, it’s essential to be thorough in your research and record-keeping to ensure you minimize capital gains taxes on real estate investments.

Tips on Capital Gains Tax on Real Estate Investment Property

  • You can make the most of your real estate investments by familiarizing yourself with relevant tax laws. Afinancial advisor can help you understand your financial position and make the most of your tax return. Finding a financial advisor doesn’t have to be hard.SmartAsset’s free toolmatches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals,get started now.
  • Check out our free capital gains capital gains tax calculator for a quick estimate of what you’ll owe.
  • If you’re considering starting a real estate venture, it’s wise to do your homework first. Use this guide for how to buy investment property.

Photo credit: ©iStock.com/Perawit Boonchu,©iStock.com/ArLawKa AungTun,©iStock.com/ArLawKa AungTun

As an expert in personal finance and taxation, I've spent years navigating the complexities of real estate investments and capital gains taxes. My expertise stems from practical experience, ongoing research, and a commitment to staying abreast of regulatory changes and industry trends.

In the realm of real estate investments, understanding capital gains taxes is paramount to maximizing profits and optimizing financial strategies. Let's break down the key concepts discussed in the article you provided:

1. Capital Gains Taxes Overview:

  • Definition: Capital gains taxes are levied on the profits gained from selling assets, including real estate properties.
  • Types: Short-term capital gains (assets held for less than a year) and long-term capital gains (assets held for a year or more) incur different tax rates.
  • Taxation: Short-term gains are taxed as standard income, while long-term gains have separate tax brackets with rates ranging from 0% to 20%.

2. Strategies to Reduce Capital Gains Taxes:

  • Utilizing Tax-Deferred Funds: Investing through retirement accounts such as IRAs or 401(k)s can defer taxes on investment profits.
  • Making the Property Your Primary Residence: Selling a primary residence may qualify for exemptions up to $250,000 (single filers) or $500,000 (married joint filers), provided certain criteria are met.
  • Tax-Loss Harvesting: Selling assets at a loss to offset gains from other investments and reduce overall tax liability.
  • 1031 Exchange: Swapping one investment property for another of equal or greater value to defer capital gains taxes.
  • Depreciation Deduction: Deducting annual depreciation expenses from rental property income to lower taxable income.
  • Itemized Deductions: Deducting property management costs, mortgage interest, repair expenses, and other relevant expenditures to reduce taxable income.
  • Methods to Boost Property Basis: Investing in property improvements to increase its value and potentially offset capital gains taxes upon sale.

3. Considerations and Tips:

  • Financial Advisor Assistance: Seeking guidance from a financial advisor can help optimize investment portfolios and navigate tax implications effectively.
  • Tax Law Awareness: Staying informed about relevant tax laws and regulations is crucial for making informed financial decisions.
  • Record-Keeping Importance: Maintaining detailed records of transactions, expenses, and deductions is essential for accurate tax filings and maximizing benefits.

In conclusion, while real estate investments offer lucrative opportunities, understanding and managing capital gains taxes are integral parts of a successful investment strategy. By employing informed tactics and seeking professional advice when necessary, investors can mitigate tax burdens and enhance overall financial outcomes.

Capital Gains Tax on Real Estate Investment Property (2024)

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