Much of all capital gains tax (CGT) that may be potentially due is never collected. Savvy rental property owners plan ahead, know the law, and they know to avoid paying capital gains tax on rental property. If they cannot avoid paying all of it, they avoid paying some of it, or they defer paying capital gains tax that may be due. In this article, we discuss what you can and should legally do to avoid paying CGT on your rental property.
There are three primary methods:
- Maximize your cost basis.
- Convert your rental property into your primary residence.
- Sell via a 1031 Exchange.
But let us begin by explaining what capital gains tax is.
What is Capital Gains Tax (CGT)?
If a rental property owner knows what CGT actually is, they are more able to plan ahead and to keep and use all necessary documents. Basically, CGT is a 15% tax paid on the profit (capital gain) when an asset is sold. In this case, we will only refer to rental property as the asset. So, if, for example, you buy a property for $200,000 and then sell it for $300,000, there is a gain of $100,000, so that would attract a tax calculated at 15% or $15,000.
But, that $100,000 notional gain can be reduced, legally excluded for tax purposes, or deferred indefinitely. Each of those three options (reduce, exclude, or defer) depend on the rental property owner's preferences, business plans, and personal circumstances.
Avoid Some Capital Gains Tax by Maximizing Your Costs Basis
The actual profit, or gain, is calculated by subtracting the "cost basis" from the net proceeds of the sold property. By keeping all appropriate records, the total cost basis can be increased. This will reduce the sale profit and, therefore, reduce the amount of tax due.
The cost basis is the property's purchase price plus the closing costs and other acquisition costs. Therefore, keep the closing statement in a safe place. Cost basis also includes the permanent improvements made to the property while you own it. Let's say you refurbish the kitchen to bring it up to date, so you can charge a higher rent to increase your monthly yield.
The new cabinets and counters are considered "permanent" so their cost increases the cost basis and reduces the capital gain when you sell. New appliances or paint for the walls are not considered permanent, so cannot be used. Detailed records listing each cost element helps to separate permanent improvement costs from maintenance costs. Without these records, you cannot prove increased cost basis if the IRS demands proof.
The closing costs when the property is sold also reduce the capital gain, so by adding all appropriate costs you will be able to avoid some capital gains tax that would otherwise be due.
Avoid up to $500,000 of Capital Gains Tax
This is where personal circumstances come into play. A primary residence has a CGT exemption built in. When a single owner sells a primary residence, the IRS excludes up to $250,000 of capital gain from tax liability. For a married couple who sell their primary residence, the exempt amount doubles to $500,000.
The IRS defines a primary residence as one where the owner uses it as such for at least two of the previous five years. The two years do not have to be consecutive. This means a rental property owner (or couple) can buy a rental property, rent it for a year, live in it themselves for a year, rent it out for the next two years, live in it for another year, then sell it, and up to $500,000 of capital gain is excluded from liability. That means they avoid up to $75,000 of CGT. If the property was bought as a fixer-upper, it would make sense to use it as a primary residence while they do the work.
If a rental property owner wants to do this, it may affect where they buy. They could buy a property close to where they live or work, or where they would like to retire for example.
Avoid Capital Gains Tax With a 1031 Exchange
A 1031 Exchange is a way of selling a rental property and buying another one by following specific IRS rules. It is a technical process that must be managed by an IRS-approved real estate specialist called an intermediary but, basically, you sell one rental property and use all the proceeds to buy another in a set period of time, and without having any access to the sale proceeds. The IRS-approved intermediary controls the funds for the sale and purchase.
By reinvesting all of the capital gain into the next purchase, you avoid any tax liability. You can sell and buy using 1031 rules as many times as you choose, and then, if you finally convert your last rental into your primary residence, you may benefit from the $500,000 exemption referred to above.
A 1031 Exchange is also called a Like-Kind Exchange or a Starker Exchange, after the Congressman who introduced the idea. This article answers many common questions but it works like this:
- You, the owner of a rental property, decide to sell it and buy one or more other rental properties. All properties must be in the United States, by the way.
- You contact, say, a real estate attorney who is an IRS-approved intermediary. Your Realtor, accountant or current attorney will know of several. The IRS does not allow you to use anyone with whom you have a current financial relationship, so even if your own attorney is approved, they will instruct you to use someone else in their network.
- You put your current property on the market and look for one or more replacement properties. If you sell your current rental for, say, $500,000, then you must reinvest all of the sale proceeds into the replacement rental(s). You could use the sale proceeds to buy another $500,000 property or, say, a $600,000 property or two $300,000 properties. What matters is you "exchange" your current rental for one or more replacement rentals (or other investment properties) of equal or greater value without you touching the sale proceeds. The intermediary holds them on your behalf until you are ready to close on the replacement(s).
- You do not have to complete a 1031 Exchange on the same day, as long as the intermediary holds the money. You must find your replacement property (or properties) within 45 days, and you must close on the purchase(s) within another 135 days, making 180 days in total to complete the exchange.
- You can have a shortlist of "possibles" which you give to the intermediary, then you settle on one or more of them and close the transactions within the 180 days.
- The intermediary does all the paperwork to satisfy the IRS so, all you are doing is buying and selling within the 180-day timescale.
These three ways will allow you to reduce, avoid or defer capital gains tax on your rentals. For more detail on forward planning, and to learn more about our services, please click here to contact us.
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