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Selling a house can come with a big tax bill. It’s one of the tough realities that’s all too often a surprise to people when they sell a rental home.
Figuring out how to sell rental and avoid taxes legally is probably more straightforward than you think it is. It’s all about making your property sale in Charlotte, NC work for you in smart ways. There’s just no reason to pay too much in taxes.
Start by thinking seriously about the tax implications of the sale of any property before selling. It might seem like an afterthought, but looking ahead and understanding the logistics of paying capital gains tax on real estate will preserve your financial status in the long run.
The basics of capital gains tax
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First off, it’s important to understand what capital gains tax is. When a rental property owner is trying to avoid paying taxes on the sale of a rental home, the biggest tax you’re trying to avoid is capital gains tax in North Carolina.
Capital gains tax is a federally assessed tax on the money made from an investment. Capital refers to the investment itself, or the “capital asset”. There are many forms that a capital asset could take, which could be shares of a company, real estate, coins or other collectibles, jewelry, bonds, and basically any kind of real property or asset that increases in value over time.
Capital gains tax is a significant concern for investors selling a rental property, and with good reason. This federal tax represents a major cut into profits on the sale of a home.
There are two kinds of capital gains tax:
- Short term capital gains tax
- Long term capital gains tax
Short term capital gains tax applies to investments that have been held for less than a year. They’re taxed at the rate of regular income tax for whatever tax bracket the individual falls into. This is a higher tax rate than most people will pay on long term investments.
Long term capital gains tax applies to investments that have been held for more than a year. These are subject to a lower tax rate than those held for less than a year because the federal government wants to encourage long term investments.
Capital gains tax is only assessed when you sell an asset or piece of property. From the time you buy it to the time you sell it, that’s the time period that the capital gains tax is assessed. Though you won’t pay on your investment until you sell, the amount you pay when you do sell rental property is based on the increase in value across the whole time you own the property.
For example, if you bought a rental property ten years ago in Matthews, NC for $200,000, then sell it this year for $300,000, you’ll owe long term capital gains tax on $100,000.
Most net capital gains tax is capped at 15% for most individuals, according to the IRS.
1 – Leveraging tax adjustments
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Tax adjustments are the things that knock down that tax cost. Adjustments include closing costs, settlement fees, real estate commissions, inspection costs, etc. Basically, every amount of money that is taken out of the profit from the sale of the home is eligible to be taken back out of the amount that the property is taxed on.
The IRS also allows rental property owners to write off home improvements. If there was a remodel, if you treated and repaired termite damage, if you tore out a moldy bathroom or replaced a roof, all of those costs can be written off. This goes for the entire time that you owned the rental property.
Remember that capital gains tax rate is assessed on the difference between the amount you paid for the house and the amount you sell the property for in Charlotte. Assuming the value of the property increased over time, you can knock down that positive difference with these adjustments.
It’s worth noting here that if you show a loss on a piece of property over time, which is unusual but possible given a housing bubble, then real estate investors avoid capital gains taxes altogether.
2 – Investment vs primary residence
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Most people who are selling a primary residence won’t have to pay capital gains tax on the profit they make from the sale. An investment property is completely different.
The federal government does this to encourage home ownership. There is a prevailing theory among economists that it’s good for everyone when people own their homes rather than renting them. Home ownership increases generational wealth, gives people more discretionary money to spend, and in general raises the standard of living of the nation as a whole.
It’s worth noting that recent economic trends are shifting. Increasingly, millennials and Gen Z are having some pushback against home ownership, both for economic reasons and philosophical reasons. Though small in scale, the push towards shared resources is growing among those demographic groups.
If you converted your primary residence into a rental property and lived there for two of the last five years, then you are eligible to avoid capital gains tax completely. This is such a good strategy that some North Carolina investors make a practice of using this legal way to avoid capital gains tax on a cycle. They buy a home, live in it for two years, then rent it out for just under three years before selling.
Getting the right rental property sales price is part of the equation, but real estate is about more than that. A rental property sale will ultimately help you recoup the investment, whether it’s been your primary residence for part of the time you’ve owned it or not.
3 – Minding the profit level
Capital gains tax only applies if you made less than a quarter of a million dollars on the sale of the home if you’re filing individually, or a half million dollars if you’re filing jointly with a spouse. This only applies if you follow the rule of living in the home for two years out of five, allowing you to mark it as your primary residence.
Don’t forget – that profit number is after you mark the profit down with the above adjustments from number one. For example, if you sell a home for $500,000 that you bought twenty years ago for $230,000, then you would make a $270,000 profit and have to pay capital gains tax on it if you’re filing individually, even if it was your primary residence. However, if you take out closing costs and other adjustments that total $30,000, then your profit is only $240,00 and you avoid paying taxes on that profit.
4 – Writing off depreciation
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Improvements that you make to a home are a major way to lower the cost basis you pay on the profit of the sale. When you deduct the amount of money you paid for improvements on a rental property, that’s depreciation. Most people do this yearly to reduce their tax burden.
From the view of the IRS, the value of a rental home depreciated over 27.5 years. That’s
All of that depreciation that you’ve written off year after year doesn’t reduce the amount of capital gains tax you own, it actually increases the capital gains tax.
Your profit on the sale, according to the IRS, is calculated by subtracting the cost basis from the selling price. For example, if you purchased a home for $200,000 and paid $20,000 in title, sale, and transfer fees, then the value of the rental property is $180,000. That’s the amount that rental property owners would pay tax on when selling a rental property.
There are two ways to calculate depreciation on a piece of property.
- tax assessment value
- appraisal value
Using a tax assessment is the easiest way to determine the depreciation expense when selling a rental property, but these are not always in the best interest of the real estate investor. Hiring an outside home appraiser in Lincolnton or Rock Hill will have an upfront cost, but an appraiser will also give a more accurate value of the depreciation expense.
Once you calculate the depreciation expense, you can then figure out how much tax you’ll save. For instance, if you paid $200,000 for a piece of rental property and calculated that you’re allowed to claim $7,000 in depreciation, then in the end you’ll be able to pay taxes on the property as though you bought it for $193,000. In the sale, the $7,000 is viewed by the IRS as you getting that depreciation back.
You’re taxed on that recaptured depreciation amount of $7,000.
Calculating depreciation is complex and involves an intersecting understanding of time, IRS tax brackets, and loss harvesting. Of everything listed here to help rental property owners avoid paying tax legally, this is the piece that is most important for you to work with a tax professional to calculate.
5 – Military tax exemption
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The military often changes the location of an assignment, and when that happens, servicemembers have no choice but to move. The IRS recognizes that this makes it difficult for them to follow the 2/5 rule for exempting a rental from capital gains tax.
To accommodate this, the IRS offers an exemption that extends that doubles that five year period to ten years. This goes for members of the foreign service, intelligence community, and other members of the armed services in North Carolina and all over the country.
The two year rule still applies, and the service member has to have been moved to a post that’s at least fifty miles from the qualifying home. They also have to have orders that send them on the new duty assignment for more than ninety days.
This is a rental property tax avoidance strategy that every member of the military should explore.
6 – Civilian relocation exemptions
It’s not just service members who can qualify for an exemption to the two-in-five rule. There are capital gains tax exemptions from the IRS for things like unforeseeable events, work relocation, and health events of homeowners.
There are specific guidelines for each kind of exemption, and you’ll want to follow them to make sure that you qualify for the exemption. Here’s the lowdown on each of them.
Unforeseeable destructive events
These are often focused on major events that affect not just you, but multiple members of your community. Think things like natural disasters – flooding, hurricanes, earthquakes, wildfires, etc. Other thigns fit into this category as well, like terrorist attacks or manmade events. The pandemic offered a great deal of tax exemptions as well. None of these are something that anyone wants to face, which is why the IRS offers tax relief.
Unforeseeable personal events
It’s not just large scale events that can help you avoid paying taxes on the sale of a rental property. Personal events like becoming legally separated or divorced, having twins or multiples in a single pregnancy, or if someone living in the home has passed away.
Loss of income or new unemployment
A change in employment status is a reason to apply for a tax exemption on capital gains tax from the sale of a rental property. If the change in employment causes you not to be able to cover basic living expenses, whether that’s because you’re unemployed or because of a reduction in your salary, it could qualify you for an exemption from the IRS.
Relocating for health reasons
If you or someone living in the home has to move for the diagnosis or treatment of an illness or injury, it’s possible to get an IRS exemption for capital gains tax. A doctor has to offer documentation of the necessity of the move for that reason. The exemption also applies if you have to move to provide personal care or medical care for a family member. Again, not a reason anyone would like to have a tax exemption, but worth looking into if you might qualify when you sell your rental property.
Relocating for employment
Similar to the service member exemption, the job relocation tax exemption applies if the new job is at least fifty miles further than your current job. For example, if your current residence is five miles from your job, then your new job has to be at least fifty five miles from your home. This also applies to unemployed homeowners who get a job that is at least fifty miles from your home.
Finally, let’s talk about investment exceptions.
Rental property owners who have a higher level of income are possibly responsible for paying net investment income tax. Most often, if you fall into this bracket you’ll know it, however if you’re close, you might not realize just how close you are and that you need to evaluate this tax.
If you do owe net investment income tax, then you’ll be responsible for 3.8% in additional taxes on investment income, including investment property that you use as a rental property. This includes capital gains and as well as taxable net income from investments.
When an investor’s modified adjusted gross income, including capital gains, is higher than certain thresholds, they owe this tax. The limits are $200,000 for someone who is filing as a head of household or is single, $250,000 for couples married filing jointly, and $125,000 for those married filing separately.
Why illegally avoiding rental property tax is a bad idea
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It should go without saying, but trying not to pay tax that you owe through any means that’s not totally above board and in line with the IRS tax code is fraudulent and a terrible idea.
Rental property offers a lucrative and potent way to make income, but that income is meaningless if you go to jail for tax fraud. Real estate investing in a smart way for business or investment purposes can make those rental properties worthwhile and profitable. Financial planning for Charlotte, North Carolina investors that includes a firm understanding of the tax rate from the Internal Revenue Service on selling a rental property will make it easier to avoid doing something shady.
The best way to go about it is the same way many real estate investors do – educate yourself on tax rates and the Internal Revenue Code, then hire a qualified real estate tax professional to help you pay the least tax on rental property.
It doesn’t matter if you own just one investment property and are far from the top tax bracket, finding the best tax solutions for your situation is something a rental property tax accountant can help you with. Working with a professional will not only help you avoid paying too much in taxes, it’ll also help you avoid getting audited by the IRS or worse
Selling rental property is hopefully a means to recoup some of the investment that you’ve put into the rental real estate. A tax bill might be necessary, but home investors should never pay more than they have to.