Real estate investments can be lucrative assets. However, they can also incur capital gains taxes that weaken your profits. Fortunately, you can implement tactics that reduce capital gains taxes so you can keep more of your money. Although the IRS taxes short-term and long-term gains differently, you can combat high tax rates on both. We’ll explain short-term and long-term capital gains and how to keep the associated taxes from costing you an arm and a leg.
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What Are Capital Gains Taxes?
You pay capital gains taxes when you profit from selling assets. You can incur two types of capital gains taxes: short-term and long-term. Short-term capital gains are from selling assets you’ve held for less than a year. On the other hand, long-term capital gains come from selling assets after holding them for a year or more. So, if you sell an investment property, the time you owned it before selling it will determine what kind of capital gains taxes you pay.
How Are Capital Gains Taxed?
The IRS taxes short-term capital gains as standard income, meaning your income tax bracket will determine your tax rate. Income tax brackets are as follows: 10%, 12%, 22%, 24%, 32%, 35%, and 37%. Your income determines your capital gains tax rates.
For example, say you make $85,000 from your day job. You sell an investment property nine months after purchasing it and make a $30,000 profit. The sale results in a short-term capital gain, and your income is $115,000 when you file taxes. In addition, you’re a single filer, putting a portion of your income in the 24% tax bracket.
Conversely, long-term capital gains have different tax rates than short-term gains: 0%, 15%, and 20%, depending on your income level and filing status. For 2023, single filers making up to $44,625 receive the 0% rate. Single filers with income between $44,626 and $492,300 will pay 15%. Finally, single filers with income above $492,300 will pay 20% long-term capital gains taxes. In addition, single filers making $125,000 or more annually will pay a net investment income tax of 3.8% on capital gains from real estate.
A married couple filing 2023 taxes jointly will pay 0% if they earn up to $89,250. The 15% rate applies if the couple earns $89,251 to $553,850. The 20% rate applies if they earn more than $553,850.
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How to Limit Capital Gains on Real Estate Investment Properties
You can use a variety of strategies to avoid capital gains on real estate properties:
Use Tax-Deferred Funds
You don’t have to invest in real estate with dollars from your bank account. Instead, you can use your [individual retirement account (IRA)](https://smartasset.com/retirement/what-is-an-ira#:~:text=Jim Barnash%2C CFP&text=The term “IRA” stands for,a 401(k) does.) or 401(k). Depositing investment profits in your investment account allows your money to grow tax-free. Plus, your IRA contributions can garner you another tax deduction.
Make the Property Your Primary Residence
The internal revenue service (IRS) exempts primary residence sales from capital gains taxes up to $500,000 for married joint filers and $250,000 for single filers. You can also avoid paying taxes on depreciation deductions this way. Using this option means fulfilling the following requirements:
Tax-Loss Harvesting