As a real estate investor, you may need to sell your rental properties at some point. Unfortunately, that can lead to a big tax bill. This leads to the question, ‘can you sell a rental property and not pay capital gains?’
Luckily, there are several ways to sell your rental property without paying capital gains. Let’s take a closer look at how you can make this happen.
If you are considering selling a rental property, you might want to take a minute to calculate capital gains on the sale of a house. Capital gains taxes come into play when you sell a property for more money than you have invested in the property. Essentially, if you make a net profit on the property’s sale, then you’ll need to pay capital gains taxes.
Depending on your income, capital gains are taxed at 0%, 15%, or 20%. In very few cases, capital gains will be taxed above 20%. You can find out which bracket you fall into on the IRS website.
Additionally, you’ll need to consider whether the capital gain is short-term or long-term. If you’ve held the property for more than a year, then it will be considered a long-term capital gain. If you’ve held the property for less than a year, then it will be considered a short-term capital gain and be taxed accordingly.
You’ll quickly realize that a tax bill for those capital gains will take a big bite out of your bottom line. With that, you’ll need to consider all of your options for reducing capital gains. Although it is not always possible to avoid capital gains tax on the sale of a rental property, there are some strategies that you can consider. Here are your options.
Offset the gains
Offsetting the gains of a sale can be an effective way to avoid paying taxes on the capital gains. You may hear this strategy referred to as tax-loss harvesting in the stock market. But it can be equally useful for real estate investors. If you have any capital losses in a given tax year, you can subtract these losses from the capital gains earned from the sale of a rental property.
For example, let’s say you sell a property and realize a capital gain of $25,000. But you’ve also chosen to sell off a portion of your portfolio to realize a loss of $25,000. With that, you can fully offset the capital gains from the sale of your rental with the loss realized in another investment.
The implementation of this strategy to avoid capital gains taxes will take some foresight. You’ll need to consider what assets can be sold at a loss to offset the gain of your rental property on sale.
Use the tax code to your advantage
If you aren’t planning to pull the gains from the sale out of your real estate portfolio, then you have an opportunity in the tax code – a 1031 exchange. These are also known as ‘like-kind’ exchanges.
Essentially, you can defer the capital gains taxes on some or all of the gain by reinvesting in another property. As long as both properties are real estate assets, then you should be able to complete the exchange without any hiccups.
The biggest issue is that you must commit to a suitable replacement property within 45 days of the sale of the original property. In addition to a commitment within 45 days, you’ll need to close on the new property within 180 days. With that, there are some obvious time constraints. But the tax savings could be worth the cost.
Live in your rental property
A final way to avoid capital gains taxes on the sale of a rental property is to use it as your primary residence.
- If you live in the property for two of the last five years, then you can walk away from the sale with a considerable capital gains tax exclusion.
- You’ll be able to exclude up to $250,000 in capital gains from the sale of your primary residence, if you are single.
- You’ll be able to exclude up to $500,000 in capital gains from the sale of your primary residence, if you are married and filing jointly.
With that, it is clear to see the benefits of using the rental property as a primary residence before you make the sale. If you are currently living in a property that you intend to rent out in the future, then you have three years to sell it after moving out to enjoy this tax benefit.
Additionally, there are some exceptions that may allow you to prorate the gain if you had to move due to an unforeseen life event. If you are interested in learning more about this rule, listen to our informative episode on the House Hacking podcast with Amanda Han.
Although it is not always convenient, the tax savings can be very significant.
How long do you have to live in your rental to avoid capital gains?
In order to enjoy the significant tax benefits, you’ll need to live in the property for two of the last five years. The years do not need to be consecutive. But the house will need to serve as a primary residence for two years.
With that, you can move in with an exit plan in mind to sell the property within three years of moving out. Or you can turn a rental into your primary residence for two years to take advantage of the savings.
Can I move into my rental property to avoid capital gains tax?
Yes, you can move into your retinal property to avoid capital gains tax. But you’ll need to use the property as your primary residence for at least two years to avoid capital gains.
Which option is right for you?
If you want to avoid capital gains tax on the sale of rental property, then you’ll likely need to plan ahead. Take some time to consider your finances and living situation. If you can find a way to avoid capital gains taxes, then you can likely accelerate your path to financial independence. However, it may not always be possible to make this happen.
Look at your long-term investment plans. Perhaps a 1031 exchange is the right path. Maybe you want to try house hacking at your rental property to avoid capital gains and lower your housing expenses at the same time. The right answer will depend on your unique situation.
If you aren’t sure what the best choice is, then talk to a CPA. A CPA can help you navigate the tricky waters of tax planning as a real estate investor. With solid guidance from a tax professional, you can breathe more easily about these decisions.
Not sure how to find a great CPA? Look for someone that is very familiar with real estate and has a specialized background to prove it. Take advantage of the top tips offered by Amanda Han on how to find a quality CPA for your real estate investment portfolio on the House Hacking podcast. The right CPA will be able to point you in the right direction.
The bottom line
No one wants to pay capital gains taxes. A big tax bill can delay your financial independence plans and real estate investment goals. Luckily, there are several ways to avoid paying capital gains. Through each of these perfectly legal options, you have the opportunity to save thousands of dollars. Think of what you could do with the savings!
If you are looking to further optimize your path to financial independence as a real estate investor, then I highly recommend considering house hacking. With the help of house hacking, you can reduce or eliminate your housing expense. Depending on your lifestyle, this could cut hundreds, or thousands, of dollars out of your monthly expenses.
Are you interested in giving house hacking a try? Check out our complete guide to house hacking today.