How To Avoid Capital Gains Tax on Rental Property

Being able to ascertain residual income is one of the primary objectives of obtaining true financial independence. Residual income is income that is received after the income-producing work has been done. The simplest example of this is buying a property and renting it out to prospective tenants.

For example, imagine you labored in a lithium mine in Chile for 30 years, after which you were finally able to buy a house in your hometown of Chattanooga. The savings you accumulated over those 30 years allowed you to buy the property and rent it out. The income you now receive from that property is considered residual income: you worked in a lithium mine to earn the money to buy the property, but now the property is receiving income independent of that previous work.

Basically, if you can accumulate enough rental properties and generate enough residual income to support your lifestyle, you can become financially independent. You’ll no longer have to do active work to bring in an income, as your residual income will be enough.

How to avoid paying capital gains tax on rental property

If you are looking to accumulate multiple rental properties, then you want to be smart about limiting the taxes you’ll pay. You might be aware of ways to limit income tax through mortgage interest deductions, but how do you mitigate capital gains tax on a rental property?

There are a variety of ways you can avoid paying capital gains taxes on property you’re renting out. 1031 exchanges, depreciation, and claiming your home as a primary residence are tried and true ways of avoiding or mitigating capital gains tax. As long as you structure your rental property the right way, file the proper exclusions, and allocate all your resources properly, you can avoid as much tax as possible and expand your portfolio of properties.

Practice enough smart tax structuring and soon you can be sipping Coronas on Pelada Beach in Nosara, Costa Rica, living exclusively off of your residual income. Let’s take a look at some strategies you can use to achieve that dream.

Capital gains taxes on rental property

You need to pay capital gains tax on any investment that you sell. However, according to the IRS, a capital gain falls under one of two categories: short-term capital gains and long-term capital gains.

If the property is sold in less than a year, then that property is taxed as normal or ordinary income. This means you should treat it as part of your income tax filing at the end of the year. However, if you hold the property for over a year, then when you sell it, you’ll pay a capital gains tax rate that correlates with your income tax bracket level. The table below explains how this works.

If you are a single filer whose income is between $40,400 and $445,850, then you will pay capital gains taxes in the amount of 15%. But, if your income exceeds $445,850, then you will be paying capital gains tax calculated at 20%. If you have variable income and happen to know which years you’re likely to receive more income, selling a rental property in the years when you have less taxable income can save you money on capital gains tax.

1031 exchange

Most real estate investors who have purchased and held assets in the United States will be familiar with the 1031 exchange program. According to the IRS, “IRC Section 1031 provides an exception and allows you to postpone paying tax on the gain if you reinvest the proceeds in similar property as part of a qualifying like-kind exchange. Gain deferred in a like-kind exchange under IRC Section 1031 is tax-deferred, but it is not tax-free.”

The program effectively lets you mitigate any capital gains tax you would otherwise incur by allowing you to swap one investment property for another. The only stipulation, according to the IRS, is that the property must be “like-kind.”

That being said, swapping any rental property for another rental property will probably fall under the IRS’s definition of like-kind. This is important to understand because there are effectively two types of property: residential and commercial. Even if you upgrade your residential-title condo to a more expensive property with a multifamily structure, it will likely count as a like-kind exchange, so you can legally avoid capital gains taxes on it.

Imagine that you own a duplex on Federal Blvd in Denver, Colorado. You paid $100,000 for the property, and now it’s worth $200,000. On paper, that’s $100,000 of capital gains that you would need to pay tax on. However, there is a multifamily home a couple of neighborhoods down that you want to buy for $1,000,000 with a deposit of $250,000. Instead of paying capital gains tax on the $100,000, you can put that toward your deposit of $250,000 and defer paying tax on the sale of your initial property.

Depreciation and depreciation recapture

Depreciation is what the IRS calculates as the loss of value of an asset over time. The idea is that assets will require upkeep over time, so an individual should be given some leeway on the taxes incurred by that asset.

Owning a property, for instance, might require you to fix flood damage or repair a leaky roof. Depreciation is a tool that can help alleviate the income tax burden on that property. According to the IRS, the lifetime of a rental property is 27.5 years. In short, that means you can deduct 3.36% of the property’s value each year from your income tax. However, when you sell the property, the IRS will want a slice of the depreciation tax breaks they gave you. This is achieved through a practice known as depreciation recapture.

For tax reasons, deprecation recapture is treated as normal income and not capital gains tax. However, as these are still taxes that need to be paid when the property is sold, you should most definitely take advantage of the IRS’s tax limits. As of 2022, the IRS can tax you up to 25% of the amount that you originally claimed for depreciation. If you take advantage of this 25% tax limit, it can help you avoid tax liability and put more money in your pocket that you can use for a deposit on another property.

It’s important to note here that you can use a 1031 exchange in conjunction with depreciation recapture. Depending on the scenario, under the 1031 exchange rule, you can defer the recapture taxes on the old property until you sell the new property that you have purchased.

Convert to a primary residence

The U.S. government wants to tax big property investors, but they don’t want to make it too hard for the little guy who just wants a roof over his head. If you can claim a property as your primary residence, then you will be exempt from a good amount of capital gains tax. This means you can avoid capital gains taxes on an investment rental property by converting it into a primary residence.

IRS Section 121 allows the conversion of investment properties, like rental properties, into primary residences. The law currently allows a deduction of up to $250,000 in capital gains for individuals and $500,000 for married couples. The only caveat is that you must have lived in the home for at least two out of the five years prior to the sale of the property.

Tax-loss harvesting

Tax-loss harvesting, unlike organ harvesting and ballot harvesting, is not as dubious as it sounds. This strategy allows you to offset losses in other investments against any gains from the sale of your property.

For instance, imagine you invested $500,000 in a stock that later lost 80% of its value. That $400,000 can act as a cushion that allows you to offset any future capital gains that you might incur from any other investment, not just another stock.

This is why you often hear about billionaires not having to pay taxes: usually, it’s because they’ve incurred significant losses in the past and now have a massive tax cushion to offset future gains. If you have unrealized losses and you haven’t sold your investments yet, you might want to consider tax-loss harvesting, especially if you have real-estate investments in rental properties that you want to buy and sell right away.

The smart way to avoid paying capital gains taxes

Honestly, the smartest way to avoid capital gains taxes on a rental property is to not sell it at all. Most investors with considerable portfolios — whether they include a few duplexes and houses in Aurora, Colorado, or sprawling multifamily properties in San Francisco, California — choose never to sell these assets. Instead, they take out their capital gains in the form of debt.

By taking equity out of your property via debt, you technically aren’t selling the property, so you are exempt from capital gains. This practice has other tax advantages as well. For instance, if you are paying interest on a mortgage in a refinancing scenario, you can get mortgage interest exclusions. If you are depreciating the assets without selling them, you can take advantage of depreciation without having to worry about depreciation recapture.

Most wealthy people in the United States take full advantage of this tax structure. Many families will have multifamily properties that they refinance and use to buy other properties. This is how wealth stays in families for generations while keeping the tax burden at a minimum.

Looking to build a property portfolio through refinancing to avoid capital gains taxes completely? Here are some mortgage refinance options you may want to consider.

FAQ

What percent is capital gains tax on rental property?

Generally speaking, this percentage varies per property. How much you pay in capital gains tax on a rental property depends on a number of factors: when you sell the property, if it’s your primary residence, if it’s a replacement property, etc.

What can be deducted from capital gains on an investment property?

Strategies like tax-loss harvesting or 1031 exchanges can be used to deduct from bottom-line capital gains tax on property.

What is the best way to avoid capital gains tax?

The best way to avoid capital gains tax is to not sell your property. Instead, refinance the property and take out the equity in the form of debt.

Can you avoid capital gains tax by reinvesting in real estate?

You cannot avoid capital gains tax entirely, but you can defer it via the 1031 exchange program.