There are a lot of property owners in Texas who dream of selling their rental homes for a tidy profit, only to have the thought of capital gains tax give them cold feet. The good news is that with the right planning and timing, there are ways to reduce or even completely defer those taxes, legally.
Texas doesn’t levy a state income tax, but federal capital gains tax and taxes on rental income can still take a big bite out of those profits. Knowing how to best manage your tax exposure helps protect more of what you’ve earned, while still staying on the right side of the IRS.
In this guide, we’ll get into the details of how a rental property sale is taxed. We’ll look at how your tax liability is determined, as well as strategies to help you pay the least amount necessary.
Tax Implications of Selling a Rental Property in Texas
While residents in Texas don’t pay state income tax, anyone selling a rental property is subject to capital gains rules. Whenever you sell a property for more than you paid, the profit is taxable income. The specifics of that tax are determined by your filing status, total income, how long you’ve owned the property, and more.
If you’ve owned the property for less than a year, any gains count as short-term capital gains. Holding for more than a year before selling qualifies the gains as long-term capital gains. This usually means a much lower tax rate.
That said, you’ll also need to report the rental income earned before the sale. If you’re unsure of how this works, partner with a tax professional with experience in real estate investing. It’s not unusual for owners to have to do this, but it can be tedious. Partner with Four19 Properties for a smooth sale process anywhere in the state.
Capital Gains Tax on Rental Property — The Basics
A capital gain occurs anytime you sell investment property for more than your adjusted basis, or cost basis. This means after you’ve adjusted for improvements, expenses, and things like that.
To find your gain, you’ll start with your purchase price. Then add your closing costs, legal fees, and qualifying rental expenses. From that number, you’ll subtract any depreciation you’ve claimed through the years, and the result is your adjusted basis.
It’s crucial to remember depreciation recapture, which can add to your tax bill if you’ve collected it. You can find more detailed capital gains tax breakdowns for the Houston area, but this is how it works in general.
How to Avoid Capital Gains on a Rental Property
In most cases, you won’t be able to escape taxes completely. However, you can use legal methods to reduce or delay them indefinitely. With the right approach, you may not have to ever pay capital gains tax on rental properties.
The most popular strategies are using a 1031 exchange, leveraging the primary residence exclusion, or relying on strategic expense tracking to limit the total liability.
Each of these options follows rules that are put in place by the IRS. Using them correctly means you can defer capital gains taxes, offset other taxable income, or even qualify for some relatively valuable deductions.
These strategies involve strict deadlines and rigid documentation requirements. As a result, it’s not the worst idea to partner with a tax professional to make sure you’re aligned with regulations.
Strategies to Reduce or Eliminate Taxes When Selling
Using a 1031 Exchange to Defer Capital Gains
A 1031 Exchange is a process that lets you sell an investment property and reinvest the profit into another of equal or greater value. When executed correctly, it lets you defer capital gains taxes owed instead of paying them immediately.
The biggest thing to remember is to follow the IRS rules. You have to identify a replacement property within 45 days, and you have to close on it within 180 days. During this time, a qualified intermediary holds the funds in escrow to maintain compliance. If the new property meets the requirements, taxes are postponed until a future sale.
Leveraging the Primary Residence Exclusion
If you’ve lived in your rental property for at least two of the past five years, you may qualify for the primary residence exclusion. This rule allows individuals to exclude up to $250,000 in gains, or $500,000 if filing jointly.
To qualify, the property must serve as your primary residence, not just an investment property. This method works best for owners who’ve recently converted a Dallas rental property into their main home, but now need to sell. It’s one of the simplest ways to reduce capital gains without complicated exchanges.
Adjusting Property Basis and Tracking Expenses
Keeping detailed records is one of the most effective ways to minimize capital gains tax. Even small adjustments can make a big difference in how much you keep.
Your adjusted basis increases when you include closing costs, legal fees, and qualified expenses such as major repairs or upgrades. This lowers your taxable gain when you sell.
You can also use tax loss harvesting to offset profits from other investments during the same tax year. Work with a tax professional or financial advisor to confirm which rental expenses and deductions qualify.
Tax Deductions and Benefits for Rental Property Owners
Being the owner of a rental property comes with a few substantial tax benefits. These benefits can be used to lower your overall tax liability.
Some of the most common deductions that can be used to lower your expenses include mortgage interest, maintenance costs, legal fees, property management costs, and insurance. You can also deduct depreciation of the property itself. This helps you recover more of the cost of your investment over time.
Selling an Investment Property — Key Considerations
Timing is critical when you’re selling an investment property. It may just be one of the most critical aspects, because it determines whether your gains are short-term or long-term. This alone has such a massive impact on the tax rates applied to the gains that it simply can’t be ignored.
Your decision to sell, and when you make that decision, can save you or cost you thousands in potential tax liability. If you’re still under the one-year cutoff and you need to sell, if you can wait until one day over the one-year mark, it can make a huge difference in your tax bill.
Whether you sell for cash or reinvest will also impact your taxes substantially. A cash sale creates immediate cash proceeds, but you’ll probably face a higher taxable gain. Using a 1031 Exchange or replacement property strategy can help you postpone those taxes for a while.
Practical Tips for Avoiding Capital Gains Taxes in Texas
- Hold the property longer. Owning for more than a year qualifies for lower capital gains tax rates. Your entry and exit strategies should be established before you invest, so you can stay on the long-term side of things.
- Reinvest your profit. Use a 1031 Exchange to defer taxes by buying like-kind property of equal or greater value. Remember, you need to close within 180 days, or the exchange is invalid.
- Use losses strategically. Apply capital losses from other investments to offset capital gains. This is where partnering with an experienced tax planner can save you untold sums in taxes and tax liability. They’ll also be the best source of advice for tax loss harvesting.
- Track expenses carefully. Save receipts for upgrades, rental expenses, and closing costs to adjust your cost basis. Every expense you can deduct is a lower tax liability in April.
- Work with professionals. A tax professional or financial advisor can create a custom plan to minimize capital gains tax and ensure compliance.
Final Thoughts on Selling Rental Property Tax-Free
Selling your Texas rental property doesn’t have to leave you with a crippling property tax bill. By taking some time to plan and getting the right guidance for that planning, you can significantly reduce what you owe or delay payment entirely until a future sale.
It all starts with you understanding not only your options, but how the capital gains tax rate figures into those options. Be sure you document every qualified expense, and fully explore the various tax-saving strategies available to you.
Conclusion
Texas investors who plan early and use smart strategies can turn a property sale into a major financial win. From tracking deductions to reinvesting through a 1031 Exchange, there are clear paths to minimize capital gains taxes without unnecessary stress.Working with experienced professionals helps you avoid mistakes and uncover opportunities to save. If you’re ready to sell a rental property and make the most of your investment, trust Four19 Properties to be your expert every step of the way. We’re committed to helping sellers find the right solution for them.