Selling Your Rental Property? Know the Capital Gains Tax Rules
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Owning a rental property is a popular way to build wealth and diversify your income. A steady rental income can act as a financial cushion whether you’re retired or still working. However, when it comes to taxes, rental properties come with extra responsibilities. Not only is the rental income taxable, but you might also owe capital gains tax when you sell the property for a profit.
How Rental Income and Capital Gains Are Taxed
Rental income is straightforward. It’s taxed as ordinary income, just like your paycheck or any side hustle earnings. The good news is that you can lower your taxable rental income by claiming deductions for expenses like maintenance, repairs and depreciation. This helps reduce the tax bite.
Things get a little more complex when you decide to sell the property. If you sell your rental for more than you originally paid, you could owe capital gains tax. The rate depends on how long you owned the property. If you’ve held it for less than a year, the profit (or “gain”) is taxed as short-term capital gains at the same rate as your regular income—as high as 37% for top earners in 2024.
If you’ve owned the property for more than a year, long-term capital gains rates apply, which are lower. Depending on your income, you’ll pay 0%, 15% or 20% in long-term capital gains taxes. For most people, this means selling a long-held rental property will come with a more manageable tax bill.
Short-Term vs. Long-Term Capital Gains Tax by Filing Status
Short-term capital gains are taxed at the same rates as ordinary income, which vary based on your tax bracket and filing status. For single filers in 2024, these rates range from 10% on incomes up to $11,600 to 37% on incomes above $609,350. Married couples filing jointly face rates ranging from 10% on incomes up to $23,200 to 37% for incomes above $731,200. For heads of household, the rates range from 10% on incomes up to $16,550 to 37% on incomes above $609,350.
Long-term capital gains, on the other hand, are taxed at much lower rates. For single filers, there is no tax on gains if their income is below $47,150. Gains are taxed at 15% for incomes between $47,151 and $518,900 and at 20% for incomes above $518,900. Married couples filing jointly can avoid taxes on gains if their income is below $94,300. Gains are taxed at 15% for incomes up to $583,750 and at 20% for incomes above that threshold. Heads of household see no tax on gains if their income is under $63,000. Gains are taxed at 15% for incomes up to $551,350 and at 20% for incomes above that amount.
Strategies to Minimize Capital Gains Tax
If you’re worried about a big tax bill when selling your rental property, there are several strategies you can use to soften the blow.
Offset Gains With Tax-Loss Harvesting: Tax-loss harvesting is a smart strategy where you balance out your capital gains with losses from other investments. For example, if you sold a rental property for a $50,000 gain but lost $20,000 in the stock market, you could use the loss to reduce your taxable gains. In this case, you’d only owe taxes on $30,000 instead of $50,000.
This strategy works best if you’ve had a mix of gains and losses in your investment portfolio. If everything you own appreciated in value, tax-loss harvesting won’t help as much, and you may need to explore other tax-saving options.
Use a 1031 Exchange to Defer Taxes: A 1031 exchange is a powerful tool that lets you defer capital gains tax when you sell a rental property, as long as you use the proceeds to buy another investment property. The IRS calls this a “like-kind exchange,” but there’s some flexibility in what qualifies. For example, selling a duplex and buying a single-family rental home would still work under the 1031 rules.
However, there are strict timelines. You must identify a new property to purchase within 45 days of selling your current one. The purchase must then close within 180 days. If you miss these deadlines, you’ll owe capital gains tax on the original sale. A 1031 exchange doesn’t eliminate your tax liability forever, but it can buy you time to reinvest and grow your wealth before eventually paying taxes.
Convert Your Rental Property to Your Primary Residence: If you’re considering moving into your rental property, this strategy could save you money on capital gains taxes. The IRS allows homeowners to exclude up to $250,000 of gains ($500,000 for married couples filing jointly) when selling a primary residence.
To qualify, you must own the home for at least five years and live in it as your primary residence for at least two of those years. For example, if you bought a rental property for $250,000, improved it, and later sold it for $400,000, the $150,000 profit could be tax-free if it meets the primary residence criteria. This can be a game-changer for landlords looking to simplify their lives while avoiding hefty tax bills.
Does a Mortgage Affect Capital Gains?
While a mortgage impacts your cash flow and interest deductions, it doesn’t directly affect your capital gains calculation. Capital gains are based on the difference between the property’s sale price and its adjusted cost basis (what you originally paid, plus any major improvements).
When you sell the property, the sale proceeds will first go toward paying off your mortgage. The remaining amount represents your profit, which determines the taxable capital gains. If you’ve deducted mortgage interest during your years of ownership, that’s an added benefit, but it won’t reduce the capital gains tax itself.
The Bottom Line
Capital gains tax can take a sizable bite out of your profit, especially if you’ve owned the property for a short time or are in a high tax bracket. The good news is that strategies like tax-loss harvesting, 1031 exchanges and converting a rental to your primary residence can help reduce or defer the tax bill. By planning ahead, you can maximize the benefits of your rental property and avoid any tax surprises when it’s time to sell.