Summary: In this article, you will learn how to calculate capital gains tax on real estate investment property. Topics also include, what are capital gains and capital losses, real estate capital gains tax rates, how to avoid capital gains tax on a rental property, and much more.
Investing in real estate is one of the best ways to generate income and build real wealth. When an investor sells a long-term rental property at a profit, they’ll enjoy a nice windfall of cash. However, they will also be liable to pay capital gains taxes on the money made from that investment property.
So what happens if tax season rolls around and capital gains taxes take half of your investment return? In reality, this scenario happens to real estate investors all the time. It’s like getting a $10,000 bonus at work and only getting $7,800 after taxes.
The good news is, there are ways for real estate investors to offset capital gains and minimize getting hit with a huge tax bill. To start, let’s jump into the basics.
Capital gains are the profits made from selling an investment. If an asset is later sold at a higher price, that “increase” would be considered a capital gain.This could be profits from selling stock market investments, real estate assets, a business, land, etc.
For example: A stock you bought 10 years ago for $5,000 is now worth $55,000. When you sell the stock, that $50k is considered a capital gain and will be taxed as such. Basically, capital gains are any investment that produces a monetary return when it’s sold. On the other hand, investors may experience capital losses with their investments, which we’ll explain next.
A capital loss is when an investment is sold for less than its original purchase price. Capital losses are significant when it comes time to file taxes because they can be subtracted from capital gains. Investors will use capital loss strategies to offset their capital gains taxes.
Capital gains from real estate investments are taxed when the asset is sold. Regardless of how much the property realizes or grows over time, investors won’t have to worry about capital gains until they sell.
These taxes can be imposed on both a state and federal level. Keep in mind that taxes on capital gains only apply to investment properties–not primary residences–as long as the homeowner lives in the home for two years or more.
Most states tax capital gains at the same rate as your federal income tax. Some states are super tax-friendly and have no income tax and no capital gains taxes. Other states have no income tax, but still tax dividends and interest. Where your rental property is located will play a major factor in how much you’ll be taxed for capital gains at a state level.
How long you own a rental property and your taxable income will determine your capital gains tax rate. Short-term investments held for one year or less are taxed at your ordinary income tax rate. Tax rates for short-term gains in 2020 are: 10%, 12%, 22%, 24%, 32%, 35% and 37%.
Investments held long-term, more than one year, will be taxed at a lower rate. The following are tax rates for capital gains on long-term real estate investments sold in 2022:
Cost basis includes expenses (i.e. closing costs, fees, etc.,) at the time of purchase and any major improvements made to the property, (a new roof, windows, or electrical system, etc.) Routine maintenance and superficial repairs/updates (new paint, light fixtures, etc.) don’t count towards your cost basis deduction.
Net Proceeds is the money you, the investor, walks away with after all the closing costs are said and done. Any costs accrued during the sale of a property can be deducted from the gross profits.
For example: Elaine bought an investment property in 2000 for $250,000. In 2020, the property sold for $550,000. Her total capital gain is $300,000, before subtracting expenses and improvement costs. Now let’s assume the following associated expenses:
In this scenario, Elaine’s cost basis would be $295,000 ($250,000+$10,000+$10,000+$25,000). Her net proceeds would be $500,000 ($550,000 – $50,000).
Now, deduct Elaine’s cost basis from her net proceeds to determine the total capital gains on the investment property.
(Net Proceeds) – (Cost Basis) = (Total Capital Gain)
$500,000 (Net Proceeds) – $295,000 (Cost Basis) = $205,000 (Total Capital Gain)
The investor will then be responsible for paying a percentage of the total capital gain, depending on their tax rate. Next, we’ll use an example to illustrate how to calculate capital gains taxes when you sell a rental property.
