Want to avoid capital gains taxes when selling your rental property? Let’s explore five strategies for effectively managing capital gains and rental property sales.
What are capital gains taxes?
When selling a property that has been used as a rental in Virginia Beach, VA or anywhere in the United States, understanding capital gains taxes is crucial.
Capital gains taxes are levied on profits made when you sell an asset. You can be charged short-term capital gains (if your asset has been held less than a year) or long-term capital gains (more than a year).
Long-term capital gains tax rates are determined by your household income, and they are set at percentages that are typically lower than the ordinary income tax rate.
Long-term Capital Gains Tax Rates 2024
Short-term capital gains tax rates are like regular income taxes – they are based on the same rate you pay on your salary and other "ordinary" income. Depending on your taxable ordinary income, the rates range from 10-37%.
How to avoid paying capital gains taxes on the sale of rental property
Here are a few creative (and legal) tax shelters to avoid paying capital gains taxes when you sell a rental property.
1. Buy & Sell Real Estate through a Retirement Account
A little-known strategy to defer or fully eliminate capital gains tax is to purchase and sell an investment property within a self-directed IRA or 401(k). You’ll want to discuss this option with a custodian that specializes in these types of retirement accounts, because not all IRAs or 401(k)s allow this type of investment.
Take note: Pulling out funds in this way may subject them to income tax, which could be charged at a rate higher than the capital gains tax rate. There are also regulations for how the property can or can’t be used to qualify without penalties.
For more information on this strategy, you can refer to resources like the IRS' website or custodians who specialize in self-directed IRAs.
Ready to invest in real estate through your retirement account? Our top real estate professionals know just how to get you started.
2. Gift Your Property Into a Charitable Remainder Trust
A lesser-known way to avoid capital gains taxes when selling a rental property is to gift it into a charitable remainder trust (CRT). This method can also create generational wealth and support a charity of your choice.
Many types of CRTs come with different tax advantages and distribution rules. But all of them receive tax-exempt non-profit status – which allows you to avoid capital gains when selling an asset within the trust. They are irrevocable trusts that can pay annual amounts to you and your beneficiaries for life or for a set time.
After the irrevocable trust period ends or the trust funds deplete, the remainder (a minimum of at least 10% of the total contributed assets) will be donated to your specified charity or donor-advised fund.
There are some limitations to this strategy for avoiding capital gains:
To gift to a charitable remainder trust, you must fully own the property with no debt.
Once gifted into a CRT, you cannot sell the property to a family member.
You cannot live on the property once it has been donated.
You cannot access all your equity at once.
If those points aren’t an issue for you, a CRT could be a great way to avoid capital gains taxes on an investment property that has appreciated significantly over time. You even get a deduction on your income taxes for donating real estate, and the funds you receive over the life of the trust will simply be taxed as ordinary income.
We highly recommend working with a CPA, financial advisor, and estate planner when considering a charitable remainder trust.
3. Convert Rental Property to a Primary Residence
If you’re open and able to live in the home for two years before selling your investment property, you can avoid paying some or all capital gains tax on the eventual sale of your property.
When you sell a primary residence that you have owned for more than two years, the IRS allows you to exclude up to $250,000 (single-filer) or $500,000 (filing jointly) in profits from your home sale. This is known as the section 121 exclusion. But when you purchase a house as a rental property, the rules for accessing that exclusion are a bit different.
If you purchased an investment property through a 1031 exchange, you have to have owned the property for at least five years and must have used it as your primary residence for 24 out of the last 60 months at the time of the sale to qualify for the section 121 exclusion.
If you didn’t acquire your rental property through a 1031 exchange, you may rent it out for a time, but you still have to live in it for at least two of the last five years before selling to qualify. Beyond those two years, there is no minimum length of ownership requirement.
Here are answers to a few FAQs about this strategy for avoiding capital gains:
You have to have lived in the home for two of the last five years. If you lived in it eight years ago, that doesn’t count.
You have to have lived in the home for two full years (24 months).
The 24 months of residence don’t have to be consecutive.
You don’t have to be living in the home when you go to sell it. It can be a rental property at the time of sale.
For those who are married and filing jointly, only one spouse must live in the property for the whole two years.
This exclusion can only be claimed once every two years.
Moving into your investment property could allow you to sell your current primary home right away. After two years, you can then sell your rental property and avoid paying capital gains tax on most, if not all, of the profit from that sale as well.
*Important: We are not tax advisors and highly recommend consulting a CPA before pursuing any tax sheltering strategies.
4. Use a 1031 Exchange to Defer Capital Gains
A 1031 exchange is essentially swapping one real estate investment for another. It’s a popular way to defer capital gains taxes when selling a rental home or even a business.
Often referred to as a “like-kind” exchange, this tax deferment strategy is defined in Section 1031 of the Internal Revenue Code. The property you gain in this exchange must be of equal or greater value to the one you relinquish (e.g. trading up a townhouse for a large single-family home, or swapping your raw land for a multi-family building).
When you sell your investment property, the profit from the sale must be held by a third-party intermediary. You have 45 days from the time you sell your original property to identify potential replacement properties and 180 days to acquire your new property. (The total time from selling the original to purchasing the replacement property must be less than 180 days total.)
You can do as many 1031 exchanges as you’d like if you meet the requirements, and you’ll only owe long-term capital gains taxes on your final sale years later – if you haven’t avoided them altogether through another strategy listed here.
There are many moving parts to a 1031 exchange, so it’s imperative real estate investors understand how a 1031 exchange works before trying to use it.
Interested in conducting a 1031 exchange in Virginia Beach? Contact us for a free consultation with a top Virginia Beach agent today.
5. Avoid Capital Gains Tax Through Tax-Loss Harvesting
The average investor won’t find this to be the best strategy, as it involves selling an asset at a loss and typically only benefits you if you have another investment or security with significant capital gains you’d like to offset.
Through tax-loss harvesting, you will sell a property for less than its adjusted cost basis (the price you paid plus capital expenses over time less depreciation). That loss can be used on your taxes to offset gains you made elsewhere that year.
If you sold other rental properties or investments for a large profit and have another rental property that’s dragging you down financially, selling at a loss could be beneficial to your financial portfolio. Otherwise, this strategy is likely not for you.
THE BOTTOM LINE
Paying taxes on the capital gains of your rental property sale may seem inevitable, but there are several legal strategies to help you avoid or defer capital gains taxes. Learning the ins and outs of these methods could save you thousands at tax time.
If you’d like to explore any of these strategies with the help of an expert, reach out to the real estate experts at CGP Team for a free consultation today!