Thinking about selling your property soon? If you do, you need to think about capital gains tax, which is a fee you pay on the profit that you gain from the sale. With this in mind, knowing how to calculate capital gains tax on investment property can help with your financial projections. To help you through this process, here’s a step-by-step guide on calculating the capital gains tax for selling a property in Texas.
Key Takeaways
- Capital gain is calculated by subtracting the net selling price from the adjusted cost basis.
- Your adjusted cost basis accounts for purchase value, cost of improvements, and depreciation recaptures.
- The capital gains tax rate depends on the length of ownership, whether short-term or long-term.
Step 1: Find Your Capital Gain by Subtracting the Adjusted Cost Basis
Coming from our experience in San Antonio property management services, we know that Texas is one of the few states in the country that does not impose state income taxes on its residents. However, we also know that despite this, property owners planning to sell a property will still pay federal capital gains tax to the IRS. With that settled, let’s jump right into how to calculate capital gains on investment property.
Let us explain the formula used to calculate your federal capital gains tax. The first thing you need to understand is that your capital gain is not immediately the amount you sold the property for. Instead, it takes into account the investments you poured into the property over time and other relevant expenses during the selling process, which will be your adjusted cost basis.
To help you visualize, the formula goes like this:
Capital Gain = Net Selling Price – Adjusted Cost Basis
Now, for the selling price, you need to take into account your selling expenses. This typically involves real estate agent commission, attorney fees, title fees, escrow, marketing, and the like. Let’s say that you sold your single-family rental property for about $350,000, and you spent around $25,000 for the real estate agent’s commission, attorney fees, and more. Your net selling price is $325,000, which is the one used in calculating the capital gain.
But what is the adjusted cost basis, and how do you come up with the figures for it? With this in mind, let’s move on to the next step.
Step 2: Determine Your Adjusted Cost Basis
As we’ve mentioned earlier, your capital gain for a property you just sold is not equal to the amount you sold it for. The formula used how to calculate capital gains tax on investment property takes into account the money you’ve put into the property while you owned it. This includes the purchase price of the property and additional costs, such as maintenance emergencies, improvements, and renovations.
For example, you bought the property years ago for around $220,000. However, throughout the years, you’ve done significant renovations to the property, such as adding a simple pool to the backyard, which cost around $40,000. On top of that, you also remodeled the kitchen for $15,000. Taking this into account, your adjusted cost basis will come up to:
Adjusted Cost Basis = $220,000 + $40,000 + $15,000
However, that is NOT yet the final figure. Part of the calculation accounts for the property’s depreciation over the years, which will be subtracted from your initial computation for the adjusted cost basis.
Step 3: Account for Depreciation Recapture
Now, how does the concept of depreciation recapture work? Let’s say that you bought a single-family property and had it rented out for several years. During this time, you’re likely to have claimed depreciation on your taxes to reduce the property taxes you need to pay. When you sell your property, the IRS recaptures this depreciation value, essentially taxing you at a specified rate (typically capped at 25%).
So, let’s say that for the 10 years that you ran your rental property business, you deducted about $7,000 in depreciation. Then, your total depreciation value upon selling the house amounts to $70,000. When you decide to sell the property, you subtract the entire $70,000 from the original cost basis to find the final adjusted cost basis.
Step 4: Apply the Appropriate Capital Gains Tax Rate
The final step in how to calculate capital gains tax on investment property is to look into your capital gains tax rate. The IRS categorizes this into two, depending on how long you’ve owned the property.
Short-term capital gains are applied to properties owned for less than a year (12 months). In this case, your capital gain is taxed simply as ordinary income. This means that your capital gain will only be taxed according to your regular income tax bracket, ranging from the percentage anywhere around 10% to 37%.
Then, there are long-term capital gains, which apply to properties owned for more than 12 months. In this case, the IRS generously lowers the capital gain tax rate, but it still depends on your appropriate tax bracket. Generally, the IRS imposes a 0% rate for the lowest income brackets, 15% for the majority, and a higher 20% rate for the highest income brackets.
Now, how does this work in calculating your final capital gains tax? Using our example for the property sold at $350,000, the computation for the capital gains tax is as follows:
- Net selling price: $350,000 – $25,000 = $325,000
- Adjusted cost basis: $220,000 (purchase price) + $40,000 + $15,000 (improvements) – $70,000 (depreciation) = $205,000
- Total capital gain: $325,000 – $205,000 = $120,000
- Depreciation recapture portion of gain: $70,000 (taxed at 25%)
- Long-term capital gains portion of gain: $120,000 – $70,000 = $50,000 (taxed at 15%)
- Depreciation recapture tax: $70,000 x 25% = $17,500
- Capital gains tax: $50,000 x 15% = $7,500
- Total federal taxes due: $17,500 (depreciation recapture tax) + $7,500 (capital gains tax) = $25,000
With these numbers, your net proceeds before tax will be $120,000 (the total gain). After you deduct the federal taxes due ($25,000), your net profit will be $95,000.
BMG: Your Trusted Property Management Partner
At first glance, understanding how to calculate capital gains tax on investment property can feel a little too complex and confusing. However, that’s not really the case. By knowing the key elements at play (selling expenses, depreciation recapture, and capital gains tax rate), you can come up with the adjusted cost basis that will help show how much you’re really profiting from the sale.
In the meantime, if you want to maximize your rental’s profit potential, that’s where Bay Property Management Group steps in. Our experienced property managers in San Antonio follow industry best practices in keeping accurate records of your expenses, improvements, and depreciation. And that’s not all. We also can handle your legal compliance, rent collection, inspections, repairs, maintenance, and more. Interested? Contact us today to get started!