To avoid capital gains tax on rental property, you must understand how it works. Read on a plain English explanation:
When you sell investment or rental property for a price for a profit, this profit is recognized as capital gains on rental property and the government wants a piece of it.
There are different capital gains tax rates depending on what type of property you own and your personal income level. Property investors are also taxed more than home owners when selling their real estate (details below). The table below show the capital gains tax rates in the United States:
Capital Gains Tax Rate
Income Tax Brackets
From the table above, we can see that someone who makes $200,000 a year will be taxed at 15% for his or her capital gains.
Note that the above tax rates only applies to long term capital gains - Meaning that you have to hold the rental property for at least 1 year before selling it.
If you sell a rental property that you have owned for less than 1 year, any profits will be classified as short term capital gains. Short term capital gains on rental property are taxed at the same rate as ordinary income tax rates (which is higher).
First step to avoid capital gains tax: U.S. tax laws treat home owners better than property investors.
The IRS identifies residential properties as either personal residences or investment properties. The big difference here is that personal residences are exempted from taxes for capital gains of up to $250,000 ($500,000 for married couples filing jointly). Investment properties do not enjoy the same privilege.
For your rental property to qualify as a personal residence, you must pass the ownership and use test. You must have owned and lived in the property as your principal residence for at least 2 out of 5 years from selling it.
Don't fret if your property fails to quality as a personal residence - There's always Section 1031 Exchange to fall back on.
Section 1031 Exchange is a tax code that allows you to defer capital gains tax if you reinvest the proceeds from your real estate sale into a like-kind property.
Terms and conditions of the Section 1031 Exchange: