Owning rental property can be a good investment with tax advantages and the potential for passive income. If your real estate appreciates in value while you own it, you may be subject to paying taxes when you decide to dispose of the property.
If you own the property for less than a year and sell it, you will owe short-term capital gains tax on the appreciation—the difference between the sales price and the cost basis. Short-term capital gains are taxed at the same rate as ordinary income, which is usually a higher rate than the long-term capital gains rate, payable on property held for more than one year.
Still, if you prefer to defer or possibly avoid paying the long-term or short-term capital gains tax rate, consider these strategies:
Don't Sell the Property
Capital gains are only realized when you dispose of an asset. The taxes that result are typically due at the subsequent tax filing. If you don't sell a property, you don't owe the taxes. If you bequeath it to an heir, that person will benefit from a one-time step-up in basis to what it is worth when they receive it.
Match a Gain With a Loss
If you want or need to sell a piece of property that has appreciated, you can use the tax-loss harvesting method to time your sale and match a loss with the gain. Simply put, if you sell the property which has gained value in the same tax year as an investment that has a capital loss, you can use the loss to offset the gain and balance the two out to help manage the taxes due.
Convert the Property to Your Residence
This strategy will not work every time but is worth considering in some circumstances. Suppose you have a rental property that you want to sell. In that case, you may be able to convert it to your primary residence for tax accounting purposes, which will allow you to exclude up to $500,000 in capital gains from being taxed ($250,000 for a single investor, $500,000 for a married couple filing jointly). If you owned the property for at least five years and have lived in it for two of the five years, it qualifies as a primary residence. The two years do not have to be consecutive, so depending on the circumstances, you may be able to manage the timing. Keep in mind that you might still owe depreciation recapture if you owned the property for a long time.
Complete a 1031 Exchange
Section 1031 of the Internal Revenue Code allows investors to exchange one investment property for another similar investment property without recognizing any gain or loss. The IRS has been flexible in applying the "like-kind" provision of the section, allowing investors to exchange residential rentals for office buildings or other commercial assets and vice versa, as long as the assets on each side of the transaction are held for business purposes.
There are strict rules and timelines associated with the exchange provisions. Also, an investor must use a qualified intermediary to complete the transaction, assuring that they do not have access to the proceeds from the disposition of the asset being relinquished and replaced. But if properly executed, the exchange allows for the repeated deferral of capital gains on real estate while an investor continues to enjoy appreciation.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation. Costs associated with a real estate transaction may impact investor's returns and may outweigh the tax benefits. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities.