The tax code in the U.S. is very friendly to real estate investors. Business and operating expenses can be deducted from gross rental income, and depreciation can be used to further reduce taxable net income.
Of course, there is no such thing as a free lunch. When the property is sold, the government expects investors to pay back some of those benefits in the form of capital gains tax. Fortunately for real estate investors, there are several ways to minimize and defer paying tax on capital gains.
In this article we'll take an in-depth look at how capital gains taxes work and discuss some strategies for reducing capital gains taxes.
What are Capital Gains Taxes?
Investment real estate generates two types of income: Recurring rental income that is taxed the year the cash flow is generated, and capital gains that are taxed when the property is sold or exchanged.
Profits made from the sale of a capital asset such as stock or real estate are classified as capital gains. A gain is realized when the asset is sold for more than the property basis, while a capital loss can occur if property is sold for less than its basis.
Part of a real estate asset's capital gain is derived from value-adds.
For example, self-storage operators can optimize unit mix by adjusting the balance of large and small units to meet customer demand and generating additional income from tenants by selling retail items such as truck rentals and insurance. Both of these value-add activities in self-storage property help to increase occupancy and property value.
Capital gains also occur because of inflation.
Although inflation erodes purchasing power, owning commercial real estate can act as a hedge against inflation. According to a study by MIT, both recurring income and property value increases from industrial property such as self-storage provide a hedge for the CPI.
Short-term capital gains
Short term capital gains occur if real estate is held for one year or less. Gains from property held short-term are treated as regular income and taxed at regular income tax rates.
Long-term capital gains
Long-term capital gains occur when the real estate is held for more than one year. Historically, investors have received preferential tax treatment because long-term capital gains are taxed a lower rate than ordinary income.
The rationale for this tax preference on long-term capital gains is two-fold. First, real estate investors have already paid taxes on the net income the property generates, and for material and supplies. Lower tax rates for long-term capital gains are also intended to help drive economic growth, by encouraging investors to be entrepreneurial and take more calculated risks.
What is the Capital Gains Tax Rate?
Investors who own real estate for more than one year qualify for the preferential long-term capital gains tax. Unlike the seven different federal income tax brackets with tax rates ranging from 10% to 37%, there are only three capital gains tax rates for 2020 and 2021:
Long-term capital gains tax rates for 2020
Single Up to $40,000 $40,001 - $441,450 Over $441,450
Married filing jointly Up to $80,000 $80,001 - $496,600 Over $496,600
Married filing separately Up to $40,000 $40,001 - $248,300 Over $248,300
Head of household Up to $53,600 $53,601 - $469,050 Over $469,050
Long-term capital gains tax rates for 2021
Single Up to $40,400 $40,401 - $445,850 Over $445,850
Married filing jointly Up to $80,800 $80,801 - $501,600 Over $501,600
Married filing separately Up to $40,400 $40,401 - $250,800 Over $250,800
Head of household Up to $54,100 $54,101 - $473,750 Over $473,750
Calculating Capital Gains Taxes
Now let us look at a simplified example of how to calculate capital gains on investment real estate.
For the purposes of this example, we'll assume the investor purchased a self-storage property five years ago for $2 million and made capital improvements of $150,000. The investor lives in Georgia and has a household income of $450,000.
If the investor sells the property for $2.5 million in 2021 he would follow these steps to calculate the capital gains:
- Calculate the basis by adding the original purchase price plus capital improvements. In this example the basis would be $2,150,000 ($2 million purchase price + $150,000 capital improvements).
- Subtract depreciation taken on the property to decrease the basis. Commercial real estate can be depreciated over 39 years straight-line (IRS Publication 946).
- Land does not depreciate, so if the self-storage property (excluding the land) had an original cost of $1,750,000 (including capital improvements) the depreciation taken take over five years would be $224,360 ($1,750,000 / 39 years = $44,872 x 5 years).
- Adjust the basis by subtracting the depreciation: $2,150,000 - $224,360 = $1,925,640 adjusted basis.
- Calculate the capital gain by subtracting the adjusted basis from the sales price: $2,500,000 sales price - $1,925,640 adjusted basis = $574,360 capital gain.
- Depreciation recapture is taxed at a flat rate of 25%. For our self-storage owner, the tax due on depreciation recapture would be $56,090 ($224,360 depreciation taken x 25% tax recapture tax).
- The remaining amount of the gain is taxed at the long-term capital gains tax rate. Since our investor is in the 15% capital gains tax bracket (married filing jointly), the tax due on the remaining portion of the gain would be $52,500 ($574,360 capital gain - $224,360 depreciation recapture = $350,000 x 15%).
- Other miscellaneous taxes. In most cases an investor will also pay a 3.8% Affordable Care Act (ACA) surtax plus any state taxes on the capital gain. In this example, other taxes due on the $574,360 capital gain would be the $21,826 ACA tax and $33,026 for Georgia state capital gains tax at a rate of 5.75%.
Keep in mind that this example is for educational purposes only. Investors should always consult their tax advisor or financial planner to understand their unique tax situation when buying or selling investment real estate.
Adjusted Cost Basis
Unlike a property purchase price or sale price, the cost basis will change or adjust over time. In the example above, when the property was purchased the cost basis was $2,150,000 (including capital improvements).
In the second year, the cost basis was reduced to $2,105,128 due to the annual depreciation expense of $44,872. If additional capital improvements of $100,000 were made at the end of the third year, the cost basis would increase to $2,160,256 ($2,105,218 adjusted basis - $44,872 depreciation + $100,000 capital improvements).
Increases in basis
Normal operating expenses such as landscaping air conditioning repairs to maintain a property and keep it in the same condition are expensed from gross income the year the repairs are made.
On the other hand, costs that generally increase the value of the property must be added to the basis and depreciated over a fixed amount of time:
- Expenses related to additions or improvements, such as replacing an HVAC unit.
- Cost of restoring a property due to weather damage, fire, or theft.
- Money spent extending utility services to the property.
- Professional service fees related to the property, such as escrow closing costs or legal fees to defend against a neighbor's encroachment.
Reductions in basis
Property basis is automatically reduced each year with depreciation, whether an investor actually claims the depreciation or not. Basis also changes if an investor claims too large of a depreciation expense, or too little.
If too much depreciation is taken, the basis is decreased by the amount that should have been deducted, plus the part of the excess deducted. If too little depreciation is claimed, the basis is decreased by the amount that should have been deducted.
Items that represent a return of cost also reduce the basis, including:
- Insurance or other payment received for a casualty or theft loss.
- Deductible loss not covered by insurance.
- Subsidies received for energy conservation, to the extent that the subsidy has been excluded from the property's gross income.
- Amount received for granting an easement, such as the neighbor who was encroaching on the property.
Strategies for Reducing Capital Gains Taxes
Our investor with the self-storage property is facing a significant tax bill due to capital gains when the property sells.
On a total pre-tax gain of $574,360 the total capital gains taxes owed, including depreciation recapture and other miscellaneous taxes, are $163,442. In other words, more than 28% of the gain is used to pay various taxes.
Of course, no investor wants to pay more taxes than they absolutely have to. The less money paid in taxes, the more capital there is left over to re-invest. Here are some of the most common ways a real estate investor can reduce capital gains taxes:
Make your investment property your primary residence
Anyone who has a rental property can use this strategy to reduce capital gains, although it will take a couple of years to accomplish. Property owners can exclude up to $250,000 in capital gains from the sale of their primary residence if the filing status is single, and up to $500,000 in capital gains when married filing jointly.
- Own home for at least five years.
- Live in the home for at least two of the five years.
- Deduction amount varies based on how long the property was used as a rental.
- Recapture tax on depreciation deduction is not excluded from the taxable gain.
Although an investor has to live in the home for two of the five years, IRS rules state that the two years don't have to be consecutive.
For example, an investor who has a pre-planned exit strategy to sell after a six-year holding period could live in the home in the first year, use it for a rental in the following four years, then move back into the home for the final year of ownership.
Tax-code Section 1031
IRC Section 1031 of the tax code allows real estate investors to defer the payment of capital gains and depreciation recapture taxes by conducting a like-kind exchange.
In the context of a 1031 exchange, like-kind means relinquishing an investment property and replacing it with another investment property. The properties do not have to be in the same asset class. For example, an investor could sell a retail shopping center and replace it with a self-storage property.
There are several guidelines a real estate investor must follow to defer paying capital gains tax by conducting a 1031 tax deferred exchange:
- Property must be like-kind and used for investment or business purposes.
- Replacement property must have an equal greater value than the relinquished property.
- Within 45 days of the close of sale of the relinquished property the investor must identify a replacement property.
- Within 180 days of the close of sale of the relinquished property the investor must close escrow on the replacement property.
Let us go back to our self-storage investor. By conducting a 1031 exchange to relinquish the existing property and replace it with another property - such as a self-storage facility in a different part of the country - the payment of $163,442 in capital gains-related taxes would be deferred, and the additional capital could be reinvested in income-producing real estate.
Investors who own a property free-and-clear (without a mortgage) or receive enough money upfront from the buyer can use an installment sale as a way to spread out paying capital gains tax.
For example, an investor who owns a small self-storage facility worth $1 million with a current mortgage balance of $200,000 could offer a seller carryback by selling the property on installment to a qualified buyer.
In this scenario, the buyer would need to make a conservative down payment of at least 30%. This allows the seller to pay off the existing mortgage and cover any closing costs.
Capital gains taxes are paid on the portion of each installment payment received from the buyer. So, rather than paying the capital gains tax all at once, payment of the capital gains tax is drawn-out over the term of the installment sale.
Investors with a capital loss in a given tax year can use tax loss harvesting to offset capital gains with capital losses.
Imagine a scenario where our self-storage investor purchased shares in an IPO recommended by his brother-in-law that promised spectacular returns. Unfortunately, the stock didn't work out as planned, and the investor is sitting on a paper loss of $50,000.
The investor decides to offset the gain from the sale of his self-storage property with the loss from the IPO. By selling the shares and creating a loss for that tax year, he could then use the $50,000 loss to partially offset the $163,442 in capital gains-related taxes owed.
Capital gains are generated when an asset such shares of a stock, a business, or real estate is sold. Capital gains taxes on rental property can take a big bite out of an investor's profits.
In fact, total capital gains-related taxes paid when a property is sold could be close to 30% of the profits, depending on an investor's income tax bracket and where the investor lives.
Fortunately, there are legal ways to defer paying capital gains tax so that profits can be reinvested in income-producing real estate instead of giving money to the government.
However, commercial real estate investors who are thinking about selling may want to act sooner rather than later. As Kiplinger reports, under President Biden's American Families Plan, people making more than $1 million per year would pay a 39.6% tax on long-term capital gains, up from the current 20% rate.
Whether or not Biden's plan makes its way through Congress is anyone's guess. It's likely that Republicans will oppose the bill, along with more moderate Democrats. But given the "tax the rich" movements across the country and the rest of the world, don't be surprised if a smaller capital gains tax increase does pass.