Purchasing an investment property can come with a number of perks—possible inflation protection and diversification to name two. Investment properties also come with a separate set of tax rules; understanding how these work can help you minimize your tax liability and make the most out of your investment.
Investment property: Tax liabilities
There are two taxes to consider if you’re hoping to generate income from investment properties: ordinary income tax and capital gains tax. Any rent you collect via leasing property you own is subject to ordinary income tax. If the property has increased in value when you go to sell, you’ll also need to pay capital gains tax on that appreciated value.
If you purchase a property for $200,000 and sell for $500,000, the $300,000 capital gain would be subject to tax.
The good news is, as long as you owned that property for longer than a year, the long-term capital gains tax rate is generally lower than the ordinary income tax rate. But there may be ways to reduce your tax liability even further.
What Goes into Capital Gains Tax on Property
The IRS uses a simple calculation for capital gains, but there are some variables involved. Understanding these variables can help you spot savings.
Cost basis
This is the amount you originally paid for the property. The sale price will be compared to the cost basis when determining your capital gain (or loss).
Adjusted cost basis
You may be able to adjust your cost basis under some circumstances. For instance, you may be able to add certain unavoidable expenses, such as legal fees and closing costs, to the number. You may also be able to adjust the cost basis to account for any major renovations or additions that impact property valuation.
Step-up basis
If property changes owners, the cost basis resets. This is important for inherited property, in particular. If your grandparents purchased a property for $25,000 and it is now worth $750,000, they would face a significant tax liability were they to sell the house. However, if they were to die and pass the house on to you as an inheritance, the cost basis would reset, or step up, to $750,000. If they gifted this property to you while alive, however, there would be no step up.
Depreciation
You may be able to depreciate the value of a rental property by 3.636% per year for 27.5 years to reduce your taxable income. You may also be able to depreciate the property faster. However, when you go to sell, depreciation recapture is taxed as income, which can increase your potential tax bill significantly.
Time owned
If you plan to own the property for a particularly short window—for instance, if you plan to flip the home—consider consulting with a tax professional.
Sale price
The final aspect that goes into determining your capital gains tax is the sale price. You’ll typically owe more in tax when the sale price is significantly higher than your cost basis. These numbers could influence your listing price because you want to ensure you get the most you can from the deal.
Understanding these terms can help you get a sense for how much you may owe in tax if you want to sell an investment property. From there, you can consider if the following tax strategies may benefit you.
1. Living there
Making a property your primary residence comes with some tax benefits. However, this rule comes with numerous restrictions, so it’s a good idea to work with a tax professional who understands the minutia.
You can sell your primary home once every two years while receiving a capital gains exemption ($250,000 per person or $500,000 per couple). You’ll have to live in the house for at least two of the previous five years to receive this benefit, and you’ll still have to pay tax on appreciation beyond the $250,000 per person limit.
2. Seller carryback
If you own the property outright, you may be able to offer a seller carryback, or seller financing, to potential buyers. The gist is that you’ll hold the mortgage for the buyer and will only owe capital gains tax on the monthly payments you receive from the purchaser.
3. Tax harvesting
If you have (or are carrying forward) any investment losses, you may be able to use them to offset a potential capital gain incurred from selling a rental property. Similarly, if you’re holding depreciated stocks with the hope that they’ll rebound, you might consider harvesting the losses when you sell a property.
4. 1031 Exchange
The IRS allows investors to defer capital gains if they use proceeds from an investment property to purchase a similar investment property. You must plan to do a 1031 Exchange in advance, and funds from the sale must move through an intermediary.
Capital gains tax is part of life, but following these strategies can help minimize your burden, at least as far as real estate is concerned. Bogart Wealth offers financial and investment management advice for our clients.
We can provide insight into the best path to take with your real estate investments, helping you make the most of their benefits. Contact Bogart Wealth for more information on our investment services.
