7 Ways to Lower Capital Gains Taxes on Real Estate

Investment properties come with a slew of tax advantages. From property depreciation to deductions, landlords have many ways to lower their taxes while owning property, but they may be surprised by a tax bill that significantly slashes their profits. 

Even worse, depreciation recapture means that the IRS will tax the deductions you made on your rental properties at even higher tax rates.

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Thankfully, there are ways to avoid capital gains tax on profits realized after a real estate sale, which greatly reduces your taxable gain — including some options that will eliminate it altogether. 

In this guide, we’ll explain the seven most common ways to reduce or avoid capital gains tax, ensuring that you retain as much profit as possible from your real estate sale

What are capital gains taxes?

The capital gains tax is a tax on the profit made by selling a capital asset, such as real estate, stocks, bonds, property, or precious metals. They are levied by the federal government and collected by the Internal Revenue Service during the same tax year that you sold your capital investment.

When do you pay capital gains tax?

You only pay capital gains tax after you have sold an asset and have not reinvested that money in another property within 180 days. If you never sell the property, you never pay capital gains tax. 

How much is capital gains tax on real estate?

There are two types of capital gains tax that are based on how long you have held the property. Long-term capital gains tax is for assets that you have held for more than a year. Your capital gains tax rate is based on your taxable income, and there are three brackets: 0%, 15%, and 20%.

Single filers or married filing separately with an ordinary income up to $44,625 pay nothing. Those with incomes up to $492,300 pay 15%, and anything above that is taxed at 20%. For married couples filing jointly, the cut-offs are a bit higher at $89,250, $553,850, and $553,851, respectively.

Assets held for less than a year are subject to a short-term capital gains tax, which is typically taxed at your ordinary income tax rate. This means that if you bought a property within the same year and your income bracket is 24%, you would have to pay about a quarter of the earnings to the government.

How to Reduce Capital Gains Tax on Property

There are seven main ways to reduce your capital gains tax liability. Some of these will even allow you to avoid paying taxes entirely on investment real estate. Before selling your property, it’s always a good idea to get professional tax advice based on your income, filing status, and how much profit you expect to make.

1. Live on the Property for Two Years

If you’ve lived in a property for at least two of the last five years, you qualify for the primary residence exclusion, also known as a Section 121 exclusion. You pay no capital gains taxes on the first $250,000 of profits from the home sale, or $500,000 if you’re married. 

So, even if you bought the property as a rental initially, you can move in for two years and then sell in order to qualify for the exclusion.

Alternatively, you can buy the property as a primary residence, using a cheaper conventional mortgage rather than a hard money loan or an investment property loan, and then move out after two years of living in it.

You can then keep it as a rental property, but you’d have to sell within three years of moving out if you want to qualify for the exclusion. As an added perk, this strategy lets you buy the property with a low down payment.

2. Meticulously Document Every Improvement

When you make “capital improvements” to an investment property, it raises your cost basis. That means you can subtract these repair costs from your sales price, along with the original purchase price, when you calculate your capital gain after selling the property.

The line can get blurry between maintenance, damage repairs, and capital improvements however, so speak with an accountant when you add up your capital improvements over the years. Regardless, you still want to keep meticulous records of all maintenance and repair costs. While repair costs don’t lift your cost basis, you can deduct them each year from your taxable cash flow.

3. Sell After You’ve Taken Other Losses

Losses on other long-term investments can offset your gains from selling a rental property. 

For example, if you took losses on stocks this year, it’s a good year to sell your property, at least from a tax perspective. Just don’t slaughter the golden goose only to avoid a little money on taxes, and remember that you can carry losses forward to future years. 

You can also try tax loss harvesting. With tax loss harvesting, you sell assets for a loss and immediately re-buy similar (but not too similar) assets. You can then rack up the capital losses to offset gains. 

For example, during a stock market crash, you could sell your shares in a small-cap index fund and immediately use the money to buy shares in a mid-cap fund. In that case, the losses you take can offset your capital gains from selling real estate.

This requires careful research into market data and data on every capital gain or loss you’ve taken over the year. If you want to pursue these methods, it’s best to work with an accountant to identify the potential capital gains tax on real estate in relation to your other investments.

4. Invest with a Self-Directed IRA

Sure, you can invest in stocks through a standard IRA at your investment brokerage. Or you can open a self-directed IRA and use it to invest in real estate. 

In particular, you'd want to open a self-directed Roth IRA, so you pay no taxes on your gains. 

That could include flipping houses, which is a great way to build up your retirement account balance quickly. When you get sick of swinging hammers, you can switch to a more hands-off buy-and-hold strategy.

If the day comes when you sell properties owned by your self-directed Roth IRA, you won't pay capital gains taxes on your profits, at least for the portion of the property that you used your cash IRA balance to buy. If you financed the property with a loan, that portion doesn't get IRA tax protections. 

5. 1031 Exchanges

Tax law lets you take your gains from selling an investment property and immediately reinvest them in a replacement property without paying capital gains tax on your profits. 

It's called a 1031 exchange, also known as a like-kind exchange or tax-deferred exchange, and you can theoretically do it indefinitely. Each time you sell a property, you can turn around and use the sale proceeds to buy a bigger property that generates more cash flow. 

You still owe capital gains taxes if you sell a property without replacing it, but rental cash flow makes for great retirement income. If you never sell the last property in the chain, you never pay capital gains taxes on any of the earlier property links in it.

6. Borrow, Don’t Sell

People sell properties because they want to cash out the equity. But you can also cash out equity by borrowing against your property rather than selling it. 

Imagine you buy a rental property with a mortgage, and over the next few decades your tenants pay off the mortgage for you. After paying it off, you could just take out another rental property loan and do it all over again. 

While you couldn’t borrow the entire value of your property, you can still cash out most of the property’s equity. All without having to give up the property — you’ll continue collecting rents and earning cash flow each month. 

7. Device The Property to Your Heirs

By combining 1031 exchanges and borrowing rather than selling, you don't ever have to sell the property, which means you never have to pay capital gains taxes on it. 

When you pass away, the cost basis of your property resets to its current value. That wipes the slate clean of all capital gains and ensures great tax benefits to your heirs.

Granted, if your estate exceeds the estate tax exemption ($13.61 million in 2024), your heirs may owe estate taxes on the overage. But otherwise, you get to enjoy rental income in retirement, borrow against the property to cash out equity if you like and pass properties to your children with no one ever having to pay capital gains taxes. 

Still, inherited homes can come with other headaches for your children, such as probate, so get strategic in your estate planning and help your children develop a solid financial plan after your passing.

The Bottom Line on Reducing Capital Gains Tax

You have plenty of options to reduce or avoid capital gains on real estate. And that says nothing of other tactics to reduce your taxes, such as rental property depreciation. There are even a few specialized situations you may be able to take advantage of. 

For example, if you were in foreign service for an extended period, you can make money selling your properties without having to pay taxes on the entire sale.

But before you take too many liberties with your tax bill, speak with an accountant or tax professional who specializes in working with real estate investors. They'll tell you not just the best way to defer taxes but, most importantly, how to avoid an audit. They can also advise you on what documentation you should keep handy in case you do get audited.

This post has been updated in May 2024 for freshness and accuracy.