Taxes on a rental property sale can quickly compile. Landlords need to be aware of these taxes and plan accordingly.
Selling a rental property comes with several tax implications that landlords need to be aware of before they consider selling. Taxes on a rental property sale can quickly add up whether you like it or not. In this article, we take a closer look at exactly what this means, what taxes you can expect, and what are the strategies of mitigating tax on the sale of a rental property.
Investment properties are taxed differently than when you sell your primary residence. When selling a rental property any profit you make on the sale is taxable as capital gains. Additionally, you will also have to contend with depreciation recapture as well as all of the associated closing costs. You may also need to pay a real estate transfer tax depending on where your property is located.
The amount of capital gains tax you owe will depend on several factors. The first is the overall profit made on the sale of the property, and the second is how long you have owned the asset.
Here is a look at the 2021 long term capital gains tax rates:
Finally, be aware that certain high-income taxpayers are also required to pay an additional 3.8% net investment income surtax, regardless of whether their gains are short or long-term.
The second tax that we mentioned above is depreciation recapture. As an investor, you probably know that you can depreciate your residential investment property over 27.5 years and write off the depreciated amount as a tax-deductible expense each year. However, when you sell the property, the IRS will reclaim some of this depreciated money in the form of depreciation recapture.
Depreciation recapture works by allowing the IRS to tax the total depreciated amount as well as the capital gains amount. Essentially, the amount deducted over time through depreciation is treated as capital gains which are taxed at a specific depreciation recapture rate when the property is sold.
In 2019, depreciation recapture on gains related to the sale of the property was capped at a maximum of 25%.
For example, you buy a property for $275,000 which allows you to deduct $10,000 a year. You hold the property for 10 years, and then sell it for $375,000.
You would pay long-term capital gains tax on the $100,000 capital gains of up to 20%. And you would also pay depreciation recapture tax on the $100,000 that you depreciated over the 10 years up to 25%.
It’s worth noting that the IRS will assume you claimed all the allowable depreciation each year and will tax you on the full amount even if you did not claim the full allowable depreciation expense.
The cost basis is the original price paid for your property plus any closing costs that must be capitalized. Basis can increase or decrease during the time a rental property is held. When the property is sold, the adjusted basis is used to calculate the amount of capital gain.
IRS Publication 551 describes in detail the basis of assets, including cost basis and adjusted basis, for real property.
There are some things that can be done to either delay or mitigate your overall tax liability when your sell your rental property. Below we outline two common methods investors use.
Tax-loss harvesting is when you offset capital gains with capital losses. The current rules allow you to offset an unlimited amount of capital gains with capital losses. If your losses are larger than your gains, you can even apply some of these losses against other forms of taxable income, up to $3,000 worth (or $1,500, if you’re married and filing separately). Any remainder can also be carried over into future tax years. Of course, for tax-loss harvesting to be applicable to you, you would need to make a capital loss in that year from other investments.
There are a couple of key things to be aware of before you explore tax-loss harvesting as an option:
A 1031 exchange is a tax regulation that allows rental property owners to defer capital gains taxes on their rental property sale. Instead of cashing out, if you reinvest the money into a like-kind property you can defer paying the capital gains tax until such a time as you do eventually sell the property for cash.
There are several rules that you must follow if you want to take advantage of the 1031 exchange rule:
Related: What Do Biden’s Tax Proposal Changes Mean for the 1031 Exchange?
As primary residences allow you to exclude up to $250,000 worth of profit from being liable for capital gains tax (or double that if you married filing jointly) you may be able to reduce your tax liability by converting a rental into a primary residence. Essentially, by living in the rental property yourself for a period of time you can claim some of this tax exclusion.
However, in order for this to work, there are a few essential rules to understand first.
Taxes on rental property sales can become complicated. If you are thinking about selling your investment property it’s advised to consult with a tax professional who can walk you through all of your options.
With their help, you should get a clearer idea of the strategies applicable to your situation.
Additionally, investors should employ a decent income and expense tracking tool such as Landlord Studio in order to keep meticulous records of all income and expenses for tax time, including depreciation. With Landlord Studio you can set recurring expenses, connect your bank feeds to view and reconcile expenses in real-time, and instantly generate customizable reports to gain nuanced insights into your portfolio.
Plus, with your first 3 properties completely fee, you’ve nothing to lose. Try Landlord Studio today and discover how it can help you stay on top of your finances for tax time.