How Do Capital Gains Taxes on Investment Properties Work?

Owning investment property is a dream for many people and is often seen as a way to gain passive income and financial security. The formula seems simple at first – as long as you can rent the property out for more than your expenses, you’re in the money… right?

Well, not always. Many people fail to consider the impact that taxes can have when it comes time to sell an investment property. And, if you’ve owned that property for less than a year, that impact can be quite large. Let’s take a look at how the IRS taxes your profit from selling investment property, known as capital gains taxes, and some ways you can lessen your tax burden.

Short-term Versus. Long-term Capital Gains Taxes

Depending on how long you have owned the investment property you are selling, the taxes you’ll owe the IRS for the sale will be categorized as short-term or long-term. For properties you owned for less than a year and sold, the taxes are considered short-term. Short-term capital gains tax is the same tax rate as your personal income, which can range from 10% to 37%.

If you owned the property for more than a year and then sold it, it is taxed at the long-term capital gains tax rate, which ranges from 0% to 20% in 2022, depending on the amount of taxable income.

Net Investment Income Tax

If your adjusted gross income is over $125,000 and you have investment income in the same year, you may be subject to an additional 3.8% tax reserved for high-income investors. Consult with a tax professional for more information about this tax and if it applies to your situation.

Calculating Capital Gains

Capital gains to be taxed are calculated by subtracting the cost basis of the property from the net proceeds of the sale. However, this is not as simple as just subtracting the purchase price of the property from the sale price.

The cost basis of the property includes:

  • The purchase price
  • Some other fees related to the purchase, such as closing costs, appraisal fees, and commissions
  • The cost of any major renovations that upgraded the property’s value or extended its use. Routine maintenance and cosmetic upgrades don’t count.

The net proceeds of the sale are the sale price, minus:

  • Realtor commissions
  • Staging costs
  • Attorney fees
  • Transfer taxes
  • Some other costs related to the sale

As you can see, using the IRS rules on determining the actual cost of a property and profits from the sale of that property can actually lower your tax burden by including some of the extra costs that go along with all real estate transactions.

Know the laws to maximize your profits

Don’t end up with an unexpected tax bill that eats up all of your investment property profits! By educating yourself on the laws and rules surrounding capital gains taxes, you can make maximum profits on your investment properties while minimizing your tax burden.