You’ve hit a wall in your cash flow, and now, you’ve decided to sell one of your rental houses to keep money flowing.
Smart thinking. Research shows that home sales are expected to slow down more than 18% in 2023 compared with 2021. In light of this, now may be the best time to put your home on the market versus waiting a few more months.
The question is, how can you avoid paying taxes on your rental property?
Here’s a rundown on how to sell a rental property without paying taxes this year.
Let’s jump in!
What Is a Capital Gain?
Capital gains are the profits you make when selling a rental or investment property. You must pay taxes on these profits to the United States government.
How Capital Gains Are Taxed
Various rates of capital gains tax exist depending on a property seller’s level of personal income and the kind of property they own.
Also, note that real estate investors are taxed at a higher rate than homeowners are when they sell real estate. However, the longer you hold the property, the lower your tax liability will be.
Let’s say that you decide to sell your rental property but you’ve owned it for 11 months or less. In this situation, the profits you generate from your sale will be deemed short-term gains.
These capital gains will be taxed at today’s tax rates for ordinary income. Unfortunately, these rates are higher than the tax rates for capital gains.
As an example, let’s say that your income is between $40,401 and $445,850 and you are single. In this situation, you may pay a tax rate of anywhere from 12% to 35% in 2022.
The same is true if you are married, you file a joint tax return with your spouse, and you earn between $80,801 and $501,600 together. In addition, it applies if you file as the head of your household and earn between $54,101 and $473,750.
Finally, the income tax rate applies to you if you are married, you are filing separately, and you earn between $40,401 and $250,800.
For example, maybe you are single, earn $50,000 a year, and generate $100,000 in capital gains. You can expect your tax rate to be 22%, which means you would owe $22,000 in taxes.
Meanwhile, if you earn $440,000 as a single person and generate capital gains totaling $100,000, your tax rate will be 35%. This translates to $35,000 in taxes owed.
Now, let’s say you have kept your rental house for more than one year. In this situation, your tax rate will max out at 15% for most individuals. For this reason, it’s best to avoid selling a rental property that you haven’t owned for at least a year.
You may be assessed a 20% tax rate on your capital gains if your income is higher than the above-listed thresholds.
How to Sell a Rental Property without Paying Taxes
If you’re wondering how to avoid capital gains tax on a rental property, the great news is that you have several options for minimizing your tax liability. Let’s take a look at four key ones.
Purchase Using the Retirement Account
One of the best ways to avoid paying tax on capital gains is to buy and sell rentals in a retirement account where taxes are deferred. These accounts include a 401(k), an Individual Retirement Account (IRA), or a Roth IRA.
Through these accounts, you can purchase a rental property with your retirement savings. Then, you can allow your capital gains and rental income to accumulate without being taxed until you make withdrawals when you are older and entering retirement.
At that time, you’ll likely have a lower income than you do now. That means your tax rate will be lower than your income tax rate or the capital gains tax rate now.
Make It Your Primary Residence
Another way to keep capital gains taxes at bay is to make the rental property you’re selling your primary home.
A primary residence is exempted from capital gains tax if the profit generated from the sale of the home is no higher than $250,000 for a single person and $500,000 for a married couple filing jointly. An investment property doesn’t receive this privilege.
However, for your rental to be deemed your residence, United States tax law requires that you have lived in it and owned it for two or more years within the five years leading up to its sale. These two years don’t need to be back-to-back.
Tax harvesting is another option for avoiding taxes on your capital gains. This process involves decreasing your tax exposure by combining your rental home’s capital gains with another investment’s loss.
Perhaps one of your investments has decreased in value, so you decide to sell this asset, and you lose money on the deal. However, within the same tax year, you sell your rental house at a profit. You can allow your loss to offset your gains and therefore avoid paying taxes on your gains.
For instance, let’s say you sell a high-value rental house and make $50,000 on the sale. However, you also lose $60,000 in today’s stock market.
In this scenario, it may behoove you to begin selling off some of your stocks. If you sell off $10,000 worth of stock, your stock market loss drops to $50,000. This amount is enough to totally offset your capital gains totaling $50,000, which means you eliminate your tax liability.
1031 Tax Deferred Exchange
Finally, you can use the 1031 exchange tax code option to defer the tax you owe on your rental property’s capital gains.
With this option, you would need to reinvest your rental home sale profits into a similar property. Then, you would need to identify the new rental property within the 45-day period following your former home’s sale. This must be done in writing.
Furthermore, the purchase of your new property must be finished within the 180-day period following your former home’s sale.
The benefit of this option is that you can wait until you retire to pay taxes on your new rental. As we mentioned earlier, your tax bracket will likely be lower then.
Alternatively, you can wait until you experience a stock market loss and use that to offset whatever capital gains you make from selling your new rental down the road.
Either way, you avoid paying taxes on your current rental home’s sale now.
Keep in mind that if you currently have a rental home designed for a single family, you can buy a larger property and still qualify for the 1031 exchange benefit. The same is true if you sell an office building and buy a handful of rental homes for single families to replace this commercial property.
What Happens to Depreciation When You Sell?
When you sell a rental property, you might also have to pay 25% in taxes for any depreciation deductions that you took within the past several years on your tax returns. It is also for deductions you perhaps didn’t take but should have taken.
You should speak with your accountant to determine how much depreciation tax you can expect to pay when you sell your rental property.
How to Avoid Depreciation
You can avoid paying depreciation recapture taxes if you live in the rental homes you are trying to sell.
For instance, perhaps you lived in your rental property for a couple of years. If these two years were within the five-year period preceding the sale of the house, you wouldn’t have to pay the depreciation tax on gains of $250,000 or lower if you are single. This threshold is higher — $500,000 — for married couples filing jointly.
Note that you can also minimize your taxes even more by deducting any investments that you make to improve your property. This can lead to huge gains and savings.
Get an Offer Through iBuyer.com
Perhaps you’re going through the rental home selling process due to an emergency or because you’re getting divorced. Either way, you’re wondering how to sell a rental property without paying taxes.
Fortunately, you can easily avoid paying capital gains tax through strategies like tax harvesting and completing a 1031 exchange.
At iBuyer.com, we can help you to sell your house in no time. All you have to do is submit your house address to get your home value and a cash offer to sell your house.