Owning investment property is a great way to diversify your income and increase the amount of money you earn each month. More than 28.1 million Americans are active property investors and with demand for rentals increasing, that number will only increase.
Though each investor has a different strategy and looks for different things in the properties they buy, most all have one thing in common: they want to eventually sell the property at a profit.
Unfortunately, you will have to pay taxes when you make a sale, but that doesn’t mean you have to pay the full amount upfront. Here are a few tips to help you reduce the amount you owe when selling investment properties.
Understand the Taxes You’ll Face
If you’re like most people, you’re selling an investment property in an attempt to earn a profit on the sale. The more money you make, the better it is for your bottom line.
However, those real estate investment profits may be subject to taxes at both the federal and state levels.
The amount you’ll owe the government depends largely on how long you’ve owned the property. For sellers who own the property for less than a year, the profit counts as a short-term gain and you could end up having to pay a tax rate of 37 percent on your profits.
For sellers who owned the property for more than a year, it’s considered a long-term gain. You’ll get taxed at a lower rate based on your total income for the year and your tax bracket for that year.
Depending on your tax bracket, it may be better to change your filing status. For example, if you’re married filing independently, you could reduce the amount you owe by filing jointly. The best thing you can do is talk to a tax professional for guidance.
Turn It Into Your Primary Residence
The capital gains tax typically only applies to investment properties. This means if you buy a house that you plan to sell for a profit, you’ll likely end up paying tax on the profits you earn.
Luckily, there’s a simple workaround. Turn the investment property into your primary residence before you sell it.
You don’t have to sell the home you’re currently living in. Instead, consider renting it to a tenant for a while or let a friend or relative use the property while you’re selling what used to be your investment property.
Even if you sell the house for more than you paid for it, you won’t end up having to pay a capital gains tax.
Keep in mind that you need to own the house for a minimum of five years and must use it as a primary residence for at least two years to qualify for the tax break. If you don’t meet these qualifications, you’ll likely have to pay the full capital gains tax.
Make Use of a 1031 Exchange
According to the IRS, 1031 exchanges allow you to use the proceeds from the sale of your first investment property to buy another investment property. When you do this, you’ll end up deferring the amount you owe in taxes until you sell and cash out on the next investment property.
The benefit of this type of exchange is that you’re free to do it more than once. You have 45 days after the sale to find a suitable property and 180 days to actually buy the property.
If you don’t use the proceeds to buy another investment property within those 180 days, you’ll have to pay the capital gains tax.
This Won’t Work If It’s Your Only Job
There are some people who make a career out of buying properties, fixing them up, and selling them at a profit. It’s lucrative and gives you control over your schedule and income. However, you won’t be able to use a 1031 exchange to offset your tax liability.
If you’re buying and selling properties as a job, you’ll have to pay taxes on those sales. If you have a day job that’s your primary source of income, you’re free to use the 1031 exchange process as many times as you want.
Take Advantage of Depreciation
The IRS allows you to deduct a rental property’s depreciation value from your taxes each year that you use it as a rental. However, you will end up paying back a portion of those deductions when you sell the property. This is true even if you don’t claim the deduction on your taxes.
That’s why you need to start taking advantage of depreciation as soon as you start renting an investment property out. Otherwise, you’ll end up paying more each year and won’t benefit from those annual savings when the time comes to sell.
Use Your Losses on Other Investments
It’s rare for all of your investments to perform well throughout the year. The IRS knows this and lets you deduct the losses you experience from your tax liability, including any capital gains tax you owe.
Use this to your advantage. If you have losses on other investments, even if they’re not related to real estate, use them to lower how much you’ll owe in capital gains.
You can even sell an investment at a loss to reduce your capital gains by the amount of that loss.
Selling Investment Properties Is a Great Moneymaker
If you’re considering selling investment properties to increase the amount of money you have at your disposal, doing so is an option. Just be mindful of the types of taxes you’ll pay and do what you can to offset your tax liability from your real estate properties.
The last thing you want to do is end up owing so much in taxes that you eat through the bulk of your real estate investing profits.
Looking for more tips to help you get the most out of your investment properties? Check out our latest posts on property investments in the Real Estate section of our blog.
