A Guide to Capital Gains Tax on Investment Properties

If you own two or more properties and sell one, capital gains tax is in your future. Capital gains taxes are as unavoidable as HOA fees—except, unlike HOA fees, this tax makes sense and has ways to manage it. Understanding how capital gains tax works can help you strategize smarter, save more, and protect your investment profits from a vacation home sale, short-term flipped properties, or long-term rentals.

Dig into the details and get equipped with the knowledge you need to keep more money in your pocket or reinvest it into your next real estate venture.

What Are Capital Gains?

Capital gains refer to the profit you make when you sell an asset—be it tangible (like investment properties, cars, or expensive furniture) or intangible (like stock market shares or patents).

The Internal Revenue Service (IRS) has specific rules around capital gains and the type of property sold, such as the section 121 home exclusion for a principal residence sale. But what if you’ve owned a second home, like a vacation property in Florida or the mountains? Or you’re a real estate investor with a simple goal: buy property, sell it for a higher price, and enjoy a good return. Maybe it’s a property you’ve inherited–all kinds of scenarios lead people to owe capital gains taxes on a real estate sale.

Figuring Out Taxes on Capital Gains

The formula to calculate your gain or loss is:

Capital Gain (or Loss) = Final Sale Price – Adjusted Basis

• Adjusted Basis: This starts with your original property purchase price. Add major improvements you made, such as repairing foundations, a new roof, a major bathroom remodel, etc.
• Final Sale Price: The amount your property sells for minus selling expenses like closing costs or real estate commission to a seller’s agent. Preparing to sell that property doesn’t come free.

If the result of this calculation is positive, you’ve got a taxable capital gain. If it’s negative, that’s a loss. Although, weirdly enough, that loss could still work in your favor tax-wise—we’ll get to this later.

Short-term vs. Long-term Capital Gains

Not all capital gains are created equal. Uncle Sam has ways of distinguishing a quick profit from a long-term investment, starting with how long you owned the asset. It breaks it into two types of capital gains.

• Short-term Gains: If you hold your property for less than a year before selling, brace yourself. Your capital gains will be taxed at your regular income tax rate. For most real estate investors, this means much higher taxes. Those dealing in fixer-upper properties need to account for this in their calculations.
• Long-term Gains: Hold your property for over a year and benefit from much lower tax rates. What you’ll owe depends on your income bracket.

Pro tip? Patience pays off—literally. Holding your investment for over a year can significantly lower your tax bill.

Capital Gains Tax Rates

As mentioned, how much you pay in capital gains depends heavily on your income level, how long you held the property, and if it was used as a rental.

The numbers below are for 2025 long-term capital gains tax rates.

• 0% Rate: This applies to married couples filing jointly with income below $96,700.  For single flier, the threshold is $48,350.
• 15% Rate: For those earning between $96,071 and $600,050 (married filing jointly) or $48,351 to $533,400 (single flier). 
• 20% Rate: This is where higher-income brackets come into play. For single fliers, that’s $533,401 or more; joint filers are $600,501.

These capital gains tax rates differ if you use married filing separately or head of household filing. Additionally, remember the IRS adjusts the federal income tax rate brackets each year to account for economic inflation and appreciation.

Short-term capital gains taxes (property holdings less than a year) are treated as ordinary income will be taxed based on that year’s federal income tax brackets.

Net Investment Income Tax (NIIT)

If that wasn’t complicated enough, there’s also the NIIT.  It’s a 3.8% tax that applies to the lesser of your net investment income or modified adjusted gross income exceeding $200,000 for single filers and $250,000 for married filing jointly. These thresholds are not adjusted for inflation.

That could mean owing 18.8% or 23.8% instead of 15% or 20%, depending on your individual tax situation.

Section 1250 Real Property

Income-producing real estate–a.k.a. rental properties or real estate with depreciation claims– are subject to a more complex layer of taxation.

If you claim depreciation on a rental property, the IRS applies a higher 25% tax rate to the portion of your gains attributed to those depreciation deductions. This is known as depreciation recapture tax—the IRS’s way of saying, “Hey, remember all those tax breaks we gave you? Yeah, we kinda want those back now.”

Section 1250 doesn’t apply to personal residences or land sales.

The 121 Home Sale Exclusion – Not for Rentals

Are you thinking of wiggling your way out of taxes with the 121 Exclusion? It only applies if the property was your primary residence for at least two out of the last five years. Rental properties don’t just sneak under this rule; they’re firmly excluded. Sorry, landlords. You also can’t apply for the exclusion twice within a two-year period.

How to Reduce Capital Gains Taxes

Of course, no one willingly wants to fork over more than necessary. The good news? There are ways to avoid (or at least soften) the capital gains tax bill. Here are some strategies:

1. Tax-Loss Harvesting: Offset your profits by pairing your taxable gains with capital losses from other investments (like underperforming stocks or mutual funds). Tax harvesting can turn a financial “oops” into a strategic win.
2. Section 1031 Exchange: Reinvest your proceeds into a “like-kind” property (typically another real estate investment) without paying immediate capital gains tax. Note that the IRS has a few hoops for you to jump through for a like-kind exchange. These include strict timelines for selling and purchasing like-kind properties and rules around the replacement property.
3. Turn Rental Into Primary Residence: Live in your investment property for at least two of the past five years, and you might qualify for the 121 Exclusion. (Warning: rent it out again, and this trick stops working.) The time you live in the property doesn’t have to be consecutive, but it must total two years.
4. Retirement Accounts: Purchasing, holding, and selling an investment property within a self-directed IRA or 401(k) allows you to defer or even eliminate capital gains tax. Make sure to work with a custodian who specializes in these retirement accounts.
5. Charitable Contributions: Feeling generous? Gifting your property into a Charitable Remainder Trust (CRT) avoids capital gains tax and lets you support a cause you care about—and potentially creates generational wealth for your family.
6. Wait a Year:  We’ve said it before, but it bears repeating: if you hold your investments (especially real estate) for more than a year, you’ll pay less, thanks to more favorable long-term capital gains taxes. Don’t rush a good thing.
7. Sell In A Low Income Year: Do you know your taxable income will be lower in a particular year? Timing the sale for this year can drop your income tax bracket, and perhaps reduce the tax rate.
8. Installment Sale: If you owe the property free-and-clear or have a low amount remaining on the loan, consider spreading out the purchase payments over several years to lower your tax burden potentially. With an installment sale, you only pay taxes on the purchase price paid in that tax year, not the full gain.

The above strategies are just a sample of what’s possible when it comes to reducing a capital gains tax hit. The best way to determine which tactics make sense for your specific situation? Consult with a qualified tax advisor who can help you navigate the nuances and complexities of capital gains tax laws. They can also assist with understanding your individual tax bracket and any potential deductions or exemptions that may apply to you. Don’t leave money on the table.

Legal Considerations for Real Estate Investors

Beyond capital gains, owning and maintaining an investment property comes with its own tax rules. Here are some potential tax deductions not to miss when real estate investing:

• Repairs and Maintenance Costs: These are deductible on your tax return in the same year so long as they’re ordinary, necessary, and reasonable. (Fixing leaks, patching a roof, or repainting walls? Deductible. Building a new wing or installing a fancy balcony? Not deductible—that’s a capital improvement.)
• Operating Expenses: Think insurance, utilities, advertising, property management fees, and legal costs. All these costs help keep the lights on and units occupied (both literally and figuratively) and can reduce your taxable income.
• Depreciation Deductions: Over time, wear and tear will lower the value of your property. Luckily, the IRS lets you deduct this devaluation. Just know that depreciation deductions may increase your tax rate when you sell due to depreciation recapture. Again, a tax professional comes in handy when calculating real estate depreciation!

The End Game On Capital Gains

Buying any real estate asset–even a part-time home–should include a long-term exit strategy. Understanding how capital gains taxes will factor in down the road is part of that exit strategy. It’s entirely manageable when you have the right knowledge ahead of time. Understanding tax laws is your ticket to protecting your profits, whether it’s a second home or managing a rental property portfolio as an active real estate investor.

And remember, an experienced tax advisor or financial planner can map the best route for your unique situation. Because while you might not control the tax code, you can certainly control how it works for you.

Disclaimer: This article is for informational purposes only and should not be used as tax advice. Please consult with a certified financial advisor or tax professional for tax recommendations.

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