Capital Gains on Rental Properties: A Comprehensive Guide
Rental properties have proven to be a great source of passive income for many people. However, before you start investing in rental properties, it is important to understand how capital gains taxes work and how they can affect your returns.
What are Capital Gains Taxes?
A capital gain is the profit you earn when you sell an asset such as real estate or stocks at a higher price than what you paid for it. Capital gains taxes are the taxes that apply to this profit. In the case of rental properties, capital gains taxes will apply when you sell the property for more than what you originally paid for it.
How much are Capital Gains Taxes on Rental Properties?
The amount of capital gains tax that applies to rental properties depends on several factors including how long you owned the property and your total taxable income.
If you held onto the property for less than a year before selling it, any profits made from the sale will be taxed as ordinary income at your regular tax rate. However, if you held onto the property for over a year before selling it, any profits made from the sale will be subject to long-term capital gains tax rates.
Long-term capital gains tax rates vary depending on your taxable income. For example:
– If your taxable income falls under $40,400 (single filers) or $80,800 (married filing jointly), then there is no federal long-term capital gain tax.
– If your taxable income falls between $40,401 – $441,450 (single filers) or $80,801 – $496,600 (married filing jointly), then long-term capital gain tax is 15%.
– If your taxable income exceeds $441,450 (single filers) or $496,601+ (married filing jointly), then long-term capital gain tax is 20%.
In addition to federal taxes on rental properties’ sales proceeds, some states also charge taxes on capital gains from real estate sales. California has the highest state tax rate at 13.3%, while other states like Florida, Nevada and Texas don’t have any state income tax.
It is important to keep in mind that these rates can change over time depending on changes in tax laws.
How to Minimize Capital Gains Taxes on Rental Properties
While capital gains taxes are unavoidable, there are several strategies you can use to minimize them:
1. Hold onto the property for at least a year before selling it: As mentioned earlier, holding onto the property for over a year will qualify you for lower long-term capital gains tax rates than if you sold it within a year of purchasing it.
2. Offset your rental property’s capital gain with losses: You can offset your rental property’s capital gain by deducting any losses incurred during that financial year or carry forward those losses to future years until they are fully utilized.
3. Make use of 1031 exchange: A 1031 exchange allows investors to defer paying their capital gains taxes when they sell their rental properties and then reinvest those proceeds into another investment property within certain guidelines established by IRS rules.
4. Use depreciation deductions: The IRS allows landlords to depreciate their rental properties as an expense deduction over the course of several years which reduces taxable income and therefore decreases potential taxes owed on sale proceeds later down the line.
5. Consult with a Tax Professional: A professional who specializes in real estate investing or taxation can help guide you through complex rules surrounding rental properties’ taxation and provide custom-tailored advice based on your individual situation.
Conclusion
Capital gains taxes are one aspect of owning a rental property that cannot be avoided entirely but minimizing them is possible through proper planning and preparation such as using depreciation deductions, doing 1031 exchanges, offsetting profits with losses among others discussed above.
When considering investing in real estate for passive income, it is important to educate yourself on the tax implications and how you can minimize them to maximize your returns.