Data source: IRS. Numbers in the chart represent taxable income, not adjusted gross income (AGI) or gross income.
In addition, certain high-income investors are required to pay an additional 3.8% net investment income tax.
The information in the chart refers to long-term capital gains, which means you owned the asset for more than a year before selling. If you sell a house you owned for a year or less, any capital gains will be considered short term, which are taxed as ordinary income according to your marginal tax rate (tax bracket) and are always higher than the corresponding long-term capital gains tax rate. So fix-and-flip investors usually cannot take advantage of the favorable long-term capital gains tax rate.
As an example, let's say you sell a rental property you've owned for five years at a $100,000 net capital gain and you're in the 15% capital gains tax bracket. You would pay $15,000 in capital gains tax on the sale.
Depreciation recapture can add to your capital gains tax bill
When it comes to selling investment property, a special type of capital gains tax applies to the portion of your adjusted basis that represents your depreciation deduction.
This tax is called depreciation recapture, and the simple explanation is that real estate investors can take annual depreciation deductions on their tax returns to reduce their taxable rental income. But once the property is sold, the IRS wants this benefit back. You can read more about depreciation recapture and how it works in this guide, but the key point is that depreciation recapture is taxed at a flat 25% rate.
How real estate investors can avoid capital gains tax
So far, we've seen that capital gains tax can be expensive, especially on highly profitable real estate sales. However, there are ways investors can avoid, postpone, or even eliminate their capital gains tax liability. Here are a few.
The most effective, commonly used strategy by real estate investors to avoid capital gains tax is known as a 1031 exchange (also called a "like-kind exchange"). This allows you to sell an investment property, use the proceeds to buy another investment property, and defer your capital gains until you sell the newly acquired property. And when the time comes to sell the new property, you can complete another 1031 exchange. In short, until you're ready to cash out, you can use the 1031 exchange strategy to defer capital gains tax indefinitely.
There is a lot to learn about 1031 exchanges before you attempt to complete one, and you'll need the assistance of a professional (known as a 1031 exchange facilitator, or qualified intermediary). But this can be a very effective way to avoid capital gains taxes when selling an investment property.
Do you have other investments that just haven't panned out? Maybe you bought a stock currently worth much less than you paid. If so, you could potentially use these losing investments to create a capital loss that will help offset your capital gains tax.
Here's how it works. Let's say you have a $20,000 taxable gain from the sale of an investment property. If you sell a stock investment you own at a $2,000 loss, it can be used to reduce your taxable capital gain to $18,000. This strategy is called tax-loss harvesting, and it is a common way investors of all kinds reduce their capital gains tax liability.
Although it doesn't help you for investment properties you already own, you can avoid future capital gains tax by owning real estate within a retirement account. While you may think of an IRA as an account that lets you buy stocks, mutual funds, and exchange-traded funds (ETFs), there are special types of accounts, known as self-directed IRAs, or SDIRAs, that allow you to put your money to work in other types of assets, including real estate.
Investment properties you hold in a SDIRA are not subject to capital gains tax when you sell for a profit, and rental income generated by these properties will not be taxable. You won't pay a dime in tax, no matter how much your real estate investments earn, until you eventually withdraw from the account (withdrawals are considered taxable income).
Primary residence exclusion
For the most part, people who sell their primary home don't pay capital gains tax. The principal residence exclusion tax break allows home sellers to exclude as much as $250,000 ($500,000 for a married couple) in capital gains on a home sale from taxes.
In most cases, this doesn't help you as a real estate investor. However, the IRS definition of a primary residence states you must have lived in the property and owned the property for at least two of the past five years -- not that you've lived in it since you owned it. For example, it's possible to own an investment property, rent it out for years, move into it for a few years, and avoid some of the capital gains tax.
The bottom line
Capital gains tax on the sale of a house can be very expensive -- especially if the property you sell was never your primary residence, you've owned it for a long time, and/or you sold it for a lot more than you initially paid. However, there are several highly effective strategies real estate investors can use to reduce, postpone, or avoid their capital gains tax when selling a house.