Along with the potential benefits of rental property ownership, is one downside. This involves annual taxes owed to the IRS, and encompasses both the rental income you might earn during your time of ownership, and the profit resulting from the sale of that property -- also known as capital gains.
Understanding capital gains on rental property, and when you pay it, is important. This information can help you better prepare for payments, when it comes time to file your tax returns. The knowledge can also help you determine strategies to potentially defer those taxes.
Capital gains versus rental income
To understand capital gains, it’s first important to understand the definition of capital assets. According to the IRS, capital assets consist of anything that is owned for “personal purposes, pleasure, business or investment.”
When you decide to acquire that duplex, office building, or small retail center as an investment, you likely do so for the anticipated steady income stream from rents.
When you acquire a capital asset, such as real estate, for investment purposes, you likely anticipate the following:
- Potential income stream from rents
- Potential appreciation of the property value
The IRS considers the anticipated rental stream ordinary income. As such, the amount you owe will depend on your income bracket, which ranges from 10% to 24% for 2020 taxes. So, when you sell that capital asset, the difference between the basis (what you originally paid for it) and the sales price is your capital gains, which are subject to taxes.
However, as with many things involving the IRS, capital gains taxes aren’t quite that straightforward.
Short-term or long-term?
The amount of capital gains taxes you pay on the sale of that property depends on how long you own it. Specifically:
- Short-term capital gains kick in when you own the property for less than one year. The gains on that sale are taxed as ordinary income which, as mentioned above, can be as high as 24%.
- Long-term capital gains occur if you sell your property after holding it for one year or longer. Proceeds on the sale of these capital gains are taxed at the capital gains tax rates which, on average, are 15%.
In other words, capital gains tax rates can be much lower than ordinary income tax rates. And, those taxes are due on the filing date following the year of your property’s disposition.
Deferring the taxes
If you aren’t interested in paying capital gains taxes right now (or around mid-April), one tax-deferral strategy is to “exchange” into another investment property. This can be done, thanks to the 26 U.S. Code § 1031 - “Exchange of real property held for productive use or investment.” Often known as the “like-kind exchange,” or the “1031 exchange,” the process allows you to place the proceeds from the sale of one asset (relinquished property) into the acquisition of another (replacement property), with help from a qualified intermediary.
If you’re tired of being a hands-on landlord, you also have the option to exchange into an investment that generates passive income, such as a Delaware Statutory Trust (DST). According to the IRS, DSTs are considered real estate, and are eligible as 1031 exchange replacement properties.
The takeaway here is that, while real estate investments can be beneficial for your investment goals, the IRS will want its share of the proceeds. As such, it’s a good idea to work with your tax professional, to ensure you understand when to pay capital gains taxes on the sale of your property.