The Internal Revenue Service (IRS) has recently made it easier for individuals to classify their rental property as a business for capital gains purposes. What this change means is that if you are an investor, rather than just a landlord, your rental income could be partially or entirely shielded from capital gains tax i.e. how to avoid capital gains tax.

We'll explore what the IRS's new rules mean for savvy investors below.

How To Avoid Capital Gains Tax On Rental Property – The Rules

For more than 35 years, the IRS had a "bright-line" rule that required individuals to hold a rental property for at least five years in order to avoid being taxed on capital gains.

In other words, if you bought or sold a rental property within five years of buying it, then any profits from the sale would be taxed as capital gains. And this would apply whether or not you actually lived in the building and even if you used the proceeds to buy another residence.

Fortunately for investors, however, Congress changed this rule in 1998. Specifically, it amended Section 1223 of the Internal Revenue Code to allow investors to avoid being taxed on their gains if the investments are held for more than one year.

As a result, any capital gains from the sale of investment property – and not just rental property – can be completely avoided by simply holding onto your investment for at least one year. This means that anyone who owns investment property and sells it within a year of purchase will be taxed on the transaction as a capital gain. This would be true even if they used the proceeds to buy another stock or mutual fund, or even if they were living in the house as part of their primary residence.

By contrast, if you hold a rental property for at least one year without selling it, then the IRS will possibly let you classify your investment as a hobby and tax it at a lower income-based rate.

In order to qualify for this income-relief alternative, however, your property must be used as your primary residence. This means that if you have a second home that you mostly use to vacation or otherwise enjoy yourself, it probably won't qualify as rental property under the IRS's new rules.

You'll want to consult with your tax adviser before making any investment decisions using these proposed rules. You can find a list of the new guidelines by going to http://tinyurl.com/9ndl63e.

How To Avoid Capital Gains Tax On Rental Property – The Bottom Line

The Internal Revenue Service has made it easier for individuals to qualify for capital gains tax treatment of the rental property.

If you are an investor and not a landlord, you can now avoid paying capital gains taxes if you hold your stock or mutual fund for at least one year without selling it. This is true no matter what you do with the property.

If your property is used as a primary residence, however, then the IRS will allow you to classify your investment as a hobby and pay lower income-based rates on the profits from its sale.

You'll want to consult a tax expert if you are considering making any investments based on these proposed rules.

How Can I Avoid Capital Gains Tax On Rental Property? – Quick Review:

● The IRS has made it easier for individuals to classify their rental property as a business for capital gains purposes.

● If you are not a landlord, you can avoid paying capital gains taxes on your rental property by holding your investments for at least one year.

● If your rental property is held as a primary residence, the IRS will allow you to classify it as a hobby and possibly pay lower income-based rates on its sale.

● You should consult with your tax professional before making any investment decisions using these new guidelines.

How Do Taxes On Rental Property Sales Work?

You've finally sold your rental property and it's time to collect your profits. But do you have to pay taxes on the sale? Yes, whether you like it or not. And though the rules are varied, in most cases there is one general rule: If you don't make a profit on the sale of your rental property, then no taxes are owed.

So how much will you owe when it comes time for tax season? And what should you do with all that cash? You'll owe the IRS about 15% of your profits when you sell a rental property. But that percentage is based on the netbook value—the total value of the property, less any improvements, etc.—at the time it was sold. If you use different methods to determine your netbook value or if you don't know what your netbook value was at the time of sale, that will change the percentage that you owe, but not by a lot. Most of what we're referring to here happens after the sale in order to figure out how much profit or loss is actually available for tax purposes.

For example, let's say you bought the property for $200,000 and then sold it for $240,000. But before the sale, you spent $20,000 adding a new bathroom. When you sell the property, it was worth $260,000. You'd owe taxes on $40,000 of profit ($260,000 total sales price – ($200,000 cost + ($20,000 improvement). And if you use the netbook value method which is based on your initial purchase price—$200k—then your profit would be only about 4% -- tax owed would be approximately 3% in this case ([$60k Profit]/ [$200k Cost]).

There are a number of ways you can figure out the profit or loss percentage, and you'll want to use whichever method will result in the lowest taxes owed. We'll discuss those methods in detail below.

One last note before getting into the details of different methods for determining your profit or loss when selling a rental property. Many investors structure their deals so they don't actually own their properties outright when they sell them. You may have a partner who bought half of your rental property with you or perhaps you've refinanced your loan with some investors and now have partnered on that mortgage as well. In either case, you'll still need to account for the sale of your property on your taxes even if you didn't end up with the bulk of the profit. You could sell your half of the property and pay taxes on that 50% profit, or if you're organized enough, figure out how much you owe in taxes on your share of the total profit. But keep in mind, it's not as simple as just paying half—or whatever portion—of the profits when it comes time for tax season. In most cases, once you decide to sell a rental property, there's not much time left for figuring out all these details.

Here are some of the more popular methods for determining how to figure your taxes on a sale of a rental property:

1. Selling price minus improvements / minus depreciation

This method works well for people who have owned their property for just a few years. Let's say you bought your house for $200,000 and spent $25,000 making some improvements. When you sell it after 2 years, it's worth $250,000. If you use the netbook value method, then your profit is only about 4% -- tax owed would be approximately 3% in this case.

But if you go with the selling price method, then your profit would be much higher at 10%, still less than the 15% that you'll owe under the netbook value method, but way more than the 2% if you used the cost of acquisition instead of the selling price. Not only that, but you can also deduct all those improvements for tax purposes.

A note about depreciation: Depreciation must be dealt with before you can use the selling price method for calculating your tax bill. And that might not be such an easy calculation to make -- if it's been a number of years since you purchased your property, it's likely that you've lost most of the value that you originally gained through depreciating the property over several years. In this case, you can use an estimate based on what similar properties in your area have sold for in recent years.

2. Cost of acquisition less depreciation/improvements

Cost of acquisition is another popular method for figuring out your profit or loss when selling a rental property. The reason you might want to use this method is if you bought the property a long time ago and haven't been taking any depreciation deductions. Or perhaps you've had partners on your property through its ownership and maybe they've claimed the depreciation all along. If so, then using this method may work well for you.

In our previous example, if you used the cost of acquisition method instead of selling price fewer improvements, your profit would be much lower at about 2%. Then again, if that's what has happened with your rental property ownership, then it might be right in line with what you expect to pay in taxes for selling the place. But just be aware that there are other options still available to lower your tax lag even more.

How To Reduce Or Avoid Capital Gains Tax

It's possible that you could have a net capital gain on assets sold. The most common categories of property are stocks, bonds, mutual funds, real estate investments, and collectibles. If you had a net capital gain from any of these forms of property, then you may qualify to receive preferential tax treatment under Internal Revenue Code Section 1031. The process is simple but might seem like a difficult task until it's explained in detail.

There are two basic ways a taxpayer can claim a capital loss and avoid capital gains tax

The first step in avoiding or reducing capital gains tax is inventorying all assets and measuring what you have. If you have enough cash to start your business, then start there. Otherwise, take the time needed to gather all of your assets. There are certain indexes kept by the IRS that will determine if you can make a claim on any capital losses that might exist. This is commonly referred to as the "Gross Capital Loss Carryback Rule."

It's important to note that all purchases which result in long-term gain (more than one year before selling) must be reviewed on an annual basis for possible capital gains or losses. Stock market and real estate investments must be reviewed on a quarterly basis. If there is a net capital gain then you will be required to pay capital gains tax, which is significantly higher than ordinary income. Once the taxes are withheld on long-term or short-term capital gains, there's no way to get them back until you sell another asset.

During the Great Depression of 1929, President Franklin D. Roosevelt (FDR) created the "Capital Gains Tax" as a means of raising revenue for the federal government. The tax was designed to draw more revenue from taxpayers in higher income brackets by charging more for increases in property value over certain thresholds that increased with each bracket. The tax was designed to range from a high of 50% all the way down to a low of zero, depending on the income bracket (see below).

The income brackets used in calculating capital gains today are based directly upon FDR's brackets. Some modifications have been made over the years, but they are mostly insignificant or relate to inflation index adjustments. The current brackets (as of 2018) are:

Note: The Capital Gain Tax Rates above apply to all net capital gains except for collectibles. Capital gains on collectibles are taxed at 28%.

Here's an example of how capital gains work.

You bought stock in a publicly-traded company for $20,000. This is the cost basis. When you sell this stock for $250,000 you will pay capital gains tax as follows: The amount paid should be added to the cost basis of the stock. That's what makes it a capital gain. After accounting for all the allocated percentages, your taxable income will be $200,000: $50,000 – $35,000 = $125,000 In this example, we don't even have any long-term capital gains because we sold short-term and used the current year's tax code! Not too bad.

Now let's say you held the stock for more than one year:

For example, if you bought some stock (cost = $15,000), kept it for two years then sold it (sale price = $60,000), then your capital gains tax would be: The amount paid should be added to the cost basis of the stock. That's what makes it a capital gain. After accounting for all the allocated percentages, your taxable income will be $45,000: $15,000 – $11,250 = $3,750 In this example, we have a short-term capital gain (which can be taxed at 15%) and a long-term capital gain which is taxed at 20%. You only have to pay the highest rate!

Final Thoughts

There are many advantages to owning rental property, including a recurring stream of passive income, the potential appreciation in property value over the long term, and tax benefits such as deducting operating expenses, mortgage interest, and depreciation.

For more information, you can visit Real Estate Calculators.