If you’re a real estate investor looking at selling a property, or if you’re thinking of buying a property now and thinking long term about selling it, then you might be worried about what taxes you’ll incur. In this blog post you’ll read about investment property taxes capital gains – what Milwaukee investors should know about capital gains.
Before you read further, you should be aware that this information is provided in general to a wide range of readers – each person reading in a different area inside or outside of WI, perhaps with different corporate structures, any many other factors. So we’re providing a helpful overview but you should always talk to an accountant and tax attorney before making any final decisions for yourself.
Different Types Of Tax For Different Types Of Income
Not all income is taxed the same way, and as a real estate investor, understanding these differences can help you maximize your profits and minimize your tax burden. Broadly speaking, income falls into three main tax categories:
- Ordinary Income Tax – This applies to wages, salaries, business income, and rental income. If you own a rental property, the rent you collect is considered ordinary income and is taxed at your regular income tax rate. However, you may be able to offset this tax burden through deductions, such as mortgage interest, property management fees, and depreciation.
- Capital Gains Tax – When you sell an investment property for a profit, the difference between the purchase price and the sale price is considered a capital gain. If you held the property for less than a year, the gain is taxed at your regular income tax rate (which can be as high as 37% in some cases). If you held it for more than a year, you qualify for the lower long-term capital gains tax rate (typically 15-20%, depending on your income bracket).
- Passive Income & Dividends – Investors who hold shares in Real Estate Investment Trusts (REITs) earn dividend income, which is often taxed at a different rate. Some dividends are qualified dividends (taxed at capital gains rates), while others are ordinary dividends (taxed as regular income).
Understanding these distinctions can help you structure your real estate investments wisely and take advantage of tax-saving strategies such as depreciation, 1031 exchanges, and opportunity zone investments.
What Are Investment Property Taxes Capital Gains?
Let’s start with the basics: When you purchase a property, the price you pay is your cost basis. When you sell the property, the amount you receive is your sale price. The difference between these two figures is your capital gain, which is subject to taxation.
However, capital gains taxes aren’t always straightforward. If you hold the property for less than a year, it’s considered a short-term capital gain and is taxed at your ordinary income tax rate, which can be significantly higher. If you hold the property for more than a year, it qualifies as a long-term capital gain, which is typically taxed at a lower rate, often 15% or 20%, depending on your income bracket.
For example, if you bought a rental property in Milwaukee for $100,000 and sold it two years later for $125,000, your taxable capital gain would be $25,000. However, certain factors, such as property improvements, depreciation, and transaction costs, can impact the final taxable amount. Investors should be aware that tax laws can change, so it’s always best to check the latest IRS guidelines or consult a tax professional before selling a property
Why Do Capital Gains Have A Different Rate?
Capital gains tax rates are typically lower than ordinary income tax rates, and this is intentional. The government provides these tax incentives to encourage long-term investment and economic growth. If capital gains were taxed at the same rate as regular income, it could discourage property sales, limit liquidity in the real estate market, and slow down economic activity.
The reasoning behind lower capital gains taxes is twofold. First, real estate and other assets appreciate over time, meaning investors often hold onto properties for years or even decades. If these gains were taxed at regular income tax rates, it would create a significant financial burden, especially for those making large sales. Second, lower capital gains tax rates serve as a government incentive to promote investment in real estate, the stock market, and other assets, helping drive overall economic stability.
However, investors should also be aware of depreciation recapture—a tax rule that applies if you’ve claimed depreciation deductions on your rental property. Upon selling, the IRS requires you to pay taxes on that amount, typically at a higher rate of 25%, which can impact your final profit. Understanding the full picture of how capital gains and depreciation work together is crucial for maximizing your investment returns.
Capital Gains On Investment Property Versus Your Primary Residence
It’s important to understand that not all real estate sales are taxed the same way. If you sell your primary residence, you may qualify for the Section 121 exclusion, which allows you to exclude up to $250,000 of capital gains from taxation if you’re single (or $500,000 if married filing jointly), provided you have lived in the home for at least two out of the last five years.
However, if you sell an investment property, these tax exclusions don’t apply. Instead, you’ll be subject to capital gains tax and potentially depreciation recapture. Some investors attempt to bypass these taxes by converting a rental property into a primary residence before selling, but there are strict IRS guidelines on how long you must live in the property before you qualify for reduced capital gains tax treatment.
Additionally, some investors use a 1031 exchange, which allows you to defer capital gains taxes by reinvesting the proceeds from your sale into another like-kind property. This strategy is particularly popular among real estate investors who want to keep growing their portfolios without triggering large tax bills upfront. Keep in mind that the IRS has strict rules on how 1031 exchanges must be executed, including timelines and reinvestment requirements. Consulting with a tax expert is critical if you plan to take advantage of this strategy.