How to Sell Your Rental Property to Avoid Capital Gains

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Posted by Troy Elston, REALTOR on March 19, 2023

If you’re considering selling your rental property, you might be worried about the capital gains tax that you’ll have to pay. Capital gains tax is a tax that you pay on the profit that you make from selling an asset, such as a rental property. The tax rate can be high, which can significantly reduce your profits from the sale.

But there are ways that you can sell your rental property and minimize the amount of capital gains tax that you have to pay. In this comprehensive guide, we’ll cover everything you need to know about selling your rental property to avoid capital gains tax.

Here’s a summary of what you’ll find on this page:

Understand Capital Gains Tax

Before we dive into strategies for avoiding capital gains tax, it’s essential to understand how it works. Capital gains tax is calculated based on the difference between the sale price of your rental property and the amount that you originally paid for it, minus any improvements that you’ve made.

For example, let’s say that you bought a rental property for $200,000 and spent $50,000 on renovations. Your total cost for the property is $250,000. If you sell the property for $300,000, your capital gain is $50,000 ($300,000 – $250,000). This is the amount that you’ll be taxed on.*

The tax rate for capital gains varies depending on your income level and how long you’ve owned the property. If you’ve owned the property for more than a year, you’ll pay long-term capital gains tax, which is typically lower than short-term capital gains tax. The tax rate can range from 0% to 20%. See the 2022 charts below.

Federal short-term capital gains tax rates

Federal tax rates on short-term capital gains are equal to income tax rates.

Tax rate Single or married filing separately Married filing jointly Married filing separately Head of household
10% $0 to $10,275 $0 to $20,550 $0 to $10,275 $0 to $14,650
12% $10,276 to $41,775 $20,551 to $83,550 $10,276 to $41,775 $14,651 to $55,900
22% $41,776 to $89,075 $83,551 to $178,150 $41,776 to $89,075 $55,901 to $89,050
24% $89,076 to $170,050 $178,151 to $340,100 $89,076 to $170,050 $89,051 to $170,050
32% $170,051 to $215,950 $340,101 to $431,900 $170,051 to $215,950 $170,051 to $215,950
35% $215,951 to $539,900 $431,901 to $647,850 $215,951 to $323,925 $215,951 to $539,900
37% Over $539,900 Over $647,850 Over $323,925 Over $539,900

Federal long-term capital gains tax rates

Tax rate Single Married filing jointly Married filing separately Head of household
0% $0 to $41,675 $0 to $83,350 $0 to $41,675 $0 to $55,800
15% $41,676 to $459,750 $83,351 to $517,200 $41,676 to $258,600 $55,801 to $488,500
20% Over $459,750 Over $517,200 Over $258,600 Over $488,500

Arizona income and capital gains tax rates

Arizona taxes capital gains as income and both are taxed at the same rates.

Tax rate Single or married filing separately Married filing jointly or head of household
2.55% $0 to $27,272 $0 to $54,544
2.98% $27,273 and over $54,454 and over

Did you know that many, but not all, states impose state-level capital gains in addition to federal capital gains taxes? To make matters more complicated, not every state uses the same methodology.

Sell Your Property as a Primary Residence

One way to avoid or minimize capital gains tax is to sell your rental property as your primary residence. If you’ve lived in the property for at least two out of the last five years, you may be eligible for the capital gains exclusion.*

Under this rule, you can exclude up to $250,000 in capital gains ($500,000 for married couples filing jointly) from the sale of your primary residence. This means that you won’t have to pay any capital gains tax on the excluded amount.

To qualify for the capital gains exclusion, you must meet the following requirements:

  • You must have owned the property for at least two years
  • You must have lived in the property as your primary residence for at least two years
  • You cannot have claimed the exclusion for the sale of another property in the last two years

If you sell your rental property as your primary residence, you’ll need to move into the property and live there for at least two years before you sell it. This strategy can be an excellent way to avoid or minimize capital gains tax, but it may not be feasible for everyone.

Use a 1031 exchange

Another way to avoid capital gains taxes when selling a rental property is to use a 1031 exchange. This is also known as a like-kind exchange. In this exchange, you can sell your rental property and use the proceeds to purchase another property. By doing so, you can defer paying capital gains taxes until you sell the new property.

To use a 1031 exchange, you need to follow certain rules. The properties involved in the exchange must be like-kind, meaning they are similar in nature, character, or use. You must also use a qualified intermediary to facilitate the exchange.

Additionally, you must identify the replacement property within 45 days of the sale of the relinquished property, and you must complete the exchange within 180 days of the sale.

While a 1031 exchange can be a great way to defer capital gains taxes, it does require careful planning and execution. You’ll want to work with a qualified intermediary and a real estate agent who has experience with 1031 exchanges.

Take Advantage of Tax Credits

In addition to the deductions and exemptions discussed above, there are also tax credits available for those who sell their rental property. One such credit is the energy-efficient home improvement credit, which is available to those who make certain improvements to their property that increase its energy efficiency.

To be eligible for this credit, you must have made improvements to the property in the past year that meet certain energy efficiency standards. Some examples of eligible improvements include installing insulation, upgrading windows and doors, and adding solar panels.

The amount of the credit depends on the cost of the improvements and the level of energy efficiency achieved. The maximum credit is $500, but this amount can be spread out over multiple years if necessary.

Another credit to consider is the low-income housing credit, which is available to those who sell rental properties that were used to provide affordable housing to low-income tenants. This credit can be quite substantial, so it’s worth investigating if you think you may be eligible.

It’s important to note that tax credits are different from deductions and exemptions. While deductions and exemptions reduce the amount of income subject to tax, tax credits directly reduce the amount of tax you owe.

This means that a tax credit is typically more valuable than a deduction or exemption of the same amount.

As with all tax matters, it’s important to consult with a professional tax advisor before taking any action to ensure that you’re making the most of all available credits and deductions.*

If you’re feeling charitable, you can even donate your rental property to a charity to avoid paying capital gains taxes. When you donate a property to a charity, you can deduct the fair market value of the property from your taxes, which can offset any capital gains taxes you would owe.

To donate your rental property to a charity, you’ll need to find a charity that is willing to accept the property. You’ll also need to have the property appraised to determine its fair market value.

While donating your rental property to a charity can be a great way to avoid capital gains taxes and support a good cause, it’s important to note that this option may not be feasible for everyone. 

Donating a property requires careful consideration, and it’s important to work with a tax professional to ensure that you’re making the best decision for your financial situation.*

Selling a rental property can be a smart financial move, but it’s important to be aware of the potential tax implications. By taking steps to minimize your capital gains taxes, you can keep more money in your pocket and make the most of your investment.

Before selling your rental property, it’s important to consider all of your options and work with a team of professionals, including a real estate agent, tax professional, and attorney, to ensure that you’re making informed decisions.

By wisely considering the above options, you can find the best way to sell your rental property and minimize your capital gains taxes in 2023.

Additional Resources Related to “How to Sell Your Rental Property to Avoid Capital Gains”

*It’s important to note that the information provided in this article is for educational purposes only and should not be taken as legal or financial advice. Tax laws can vary by country and even by state, so it’s crucial to consult with a professional tax adviser before making any decisions about selling a rental property or any other major financial transactions. They can provide personalized advice based on your individual circumstances and help you navigate the complexities of tax laws to minimize your tax liability. Always seek professional guidance when making financial decisions that could have a significant impact on your finances.

Sources for Tables

Arizona State Senate (2021). “FACT SHEET FOR S.B. 1828/H.B. 2900.”
Internal Revenue Service (2022). “26 CFR 601.602: Tax forms and instructions.”

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Troy Elston is licensed Realtor in Phoenix Arizona. With over 20 years experience in real estate sales, Troy offers the highest degree of experience, service and integrity in the industry.
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