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taxes on rental property sale

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.

What taxes will you need to pay when you sell 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.

Capital Gains Tax On Rental Property

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.

  • Short-term capital gains are taxed at a higher rate and will occur if you sell the property after holding it for less than a year. Generally, this will be the case for properties that you fix and flip. Short-term capital gains are taxed at the same rate as your ordinary income meaning the eventual capital gains tax owed on the sale of the rental property would depend on your tax bracket.
  • Long-term capital gains are taxed at a more favorable rate limited to 20%. For the property to qualify for long-term capital gains you need to have held it for longer than a year. The rate at which the profits are then taxed will still be dependent on the taxable income you have for that year.

Here is a look at the 2021 long term capital gains tax rates:

Capital Gains Tax Rate Taxable Income (Single) Taxable Income (Married Filing Jointly)
0% Up to $40,400 Up to $80,800
15% $40,401 to $445,850 $80,801 to $501,600
20% Over $445,850 Over $501,600

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.

What is depreciation recapture and how is it calculated?

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.

What Is Your Property Cost Basis?

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.

Items That Increase Your Propertys’ Cost Basis

  • Inspection and appraisal fees
  • Recording fees and owner’s title insurance
  • Real estate commission
  • Cost of additions or improvements
  • Assessments that increase property value

Items That Decrease Your Propertys’ Cost Basis

  • Depreciation
  • Amount received for granting an easement
  • Casualty or theft loss deductions

IRS Publication 551 describes in detail the basis of assets, including cost basis and adjusted basis, for real property.

How To Minimize Your Taxes On Rental Property Sale

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

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:

  • Tax-loss harvesting can only be applied to taxable investments. Accounts like your 401k allow you to defer paying taxes and so these investments aren’t subject to capital gains.
  • Tax-loss harvesting can be used for both short-term and long-term gains. Long-term losses are first applied against long-term gains and then against short-term gains. Meanwhile, short-term losses are applied first to short-term gains.
  • Be aware of wash-sale rules which stipulate that you cannot use a sale as a loss if you then purchase a similar security within 30 days. The idea of this rule is to prevent investors from intentionally creating losses to offset their tax liabilities.

1031 like-kind exchange

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:

  • This exchange can only be used on business assets
  • Once the initial property has been sold you will need to identify the property that you intend to “swap” for within 45 days.
  • You have 180 days after selling your property to close on the new property.
  • Any cash not used when purchasing the new property is taxable as a partial capital gain.

Related: What Do Biden’s Tax Proposal Changes Mean for the 1031 Exchange?

Turn the property into a primary residence

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.

  • The property will need to serve as your primary residence for at least 2 of the last 5 years.
  • You will still be liable for depreciation recapture tax for any amount of depreciation allowed over the years the property served as a rental.
  • A percentage of gains will still be taxable according to a tax law change that was implemented in 2009. You can find this percentage by taking the number of years after 2009 that the property served as a rental and dividing that number by the total number of years that you’ve owned the property.

Taxes On Rental Property Sale: Final Words

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.

Rental Property Accounting

Ben Luxon

Ben is the editor and lead writer for Landlord Studio. He has worked with real estate professionals all over the world and written educational articles on tech, real estate, and financial growth for sites such as Forbes, TechBullion, and Business Magazine.

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