What taxes will you pay on the sale of rental property?
Thinking about selling your rental property? First, consider the tax implications. Capital gains and depreciation recapture taxes can take a serious bite out of your profits. If you’ve owned the property for a long time, these taxes are likely to be higher. In fact, the average rental property in the U.S. owned for 25 years will lose a third of its value in taxes when it is sold.
The good news: There are ways to defer those taxes. Here’s what you need to know.
Capital Gains Tax
If you sell an investment for more than you paid to acquire it, you have a capital gain. For example, if you buy stock for $10,000 and sell it a few years later for $12,000, you have a $2,000 capital gain. It doesn’t matter if the stock shoots up to $20,000 or $50,000 while you own it. Those gains are unrealized, and they don’t trigger taxes. Once you sell the investment, however, you owe capital gain taxes on the realized gains.
The same applies to the sale of rental property. The tax rate depends on how long you owned the property:
- Less than one year. Gains are considered a short-term gain and are taxed as ordinary income (capped at 37% for 2020).
- More than one year. Gains are considered long-term gain and are taxed at 0%, 15%, or 20% (for 2020), depending on your income and filing status.
High-income taxpayers may owe an additional 3.8% net investment income tax, whether they have a short-term or long-term gain.
There are some exceptions to the capital gain taxes if you lived in your property. You can exclude up to $250,000 of gains (or $500,000 if you’re married filing jointly) when you sell provided:
- The house is your primary residence,
- You lived in the house for at least two of the last five years, and
- You owned the house for at least two of the last five years.
If your rental property doesn’t meet these requirements, you’ll be on the hook for the capital gains tax on the entire amount.
To calculate capital gains, you need to determine two numbers: The cost basis and the net proceeds. The cost basis is the amount you paid to acquire the property — including the purchase price, some closing costs, appraisal fees, and legal fees — plus the cost of any major improvements you made to the property.
The net proceeds are what you make from the sale, less any associated costs, such as the real estate agent’s commission, home staging, house cleaning, lawyer fees, and transfer taxes.
To calculate capital gain (or loss) on your rental property, subtract the cost basis from the net proceeds. If it’s a positive number, that’s the amount on which you’ll owe capital gains tax.
Depreciation Recapture Tax
As a rental property owner, one of the deductions you can take is for depreciation. Most rental property is depreciated over 27.5 years — what the IRS considers the “useful life” of the property (land doesn’t get “used up” or become obsolete, so it doesn’t get depreciated). That means you can deduct 3.636% of your cost basis each year, which can be a nice perk at tax time.
Of course, the IRS remembers those deductions and will want some of that money back when you sell. This is where the depreciation recapture tax comes in. The tax applies to the amount of gain that can be attributed to the depreciation deductions you took while you owned the property.
Keep in mind that you can’t avoid depreciation recapture by not taking the deduction — it won’t work. The IRS will want to recapture the amount you should have deducted, whether you actually did or not.
1031 Exchanges
A popular strategy that some real estate investors use to defer paying taxes is a Section 1031 exchange — aka a like-kind exchange. 1031 exchanges are complicated, and you should fully understand the process — including the use of qualified intermediaries — before using this strategy. Ideally, a 1031 exchange should always be handled by a professional.
To execute a 1031 exchange, you sell one property and buy another “like-kind” property with the sale proceeds. By reinvesting the proceeds, you defer paying both capital gains and depreciation recapture taxes.
For a transaction to qualify as a 1031 exchange, you must:
- Identify the replacement property within 45 days of selling the original property and acquire it within 180 days.
- Replace the original property with a “like-kind” property. According to the IRS, properties are of like-kind if they’re of the same nature or character, even if they differ in grade or quality. That doesn’t mean you have to exchange an apartment building for another apartment building. As long as it meets the IRS definition for like-kind, you can exchange vacant land for an apartment building, for example, or a warehouse for an office building.
- Pay tax in the year you make the exchange on any boot. That’s the fair market value of cash, benefits, and other property that’s not the like-kind property that you receive in the exchange.
One of the stipulations for 1031 exchanges is that the properties must be held for investment or business purposes. That means any property you hold for personal use — such as your primary residence — can’t be used in a 1031 exchange.
Still, many investors convert primary residences into rental properties. In general, you can use the property in a 1031 exchange if you rent it out (e.g., use it for investment purposes) before doing the exchange.
While the tax code doesn’t specify how long you must rent it out, tax professionals generally agree that two years is long enough, provided you can prove you used the property for investment purposes.
How Flock Can Help
By joining Flock, you’ll avoid the typical taxes triggered by a sale of rental property, including capital gains and depreciation recapture taxes, to receive shares equal to the value of your property. The exchange is done on a tax-deferred basis, similar to a 1031 — but without the hassles of finding a qualified intermediary, finding a replacement property, and continuing to own real property.
Submit your property for a free valuation here.
1. https://www.zillow.com/research/zhvi-methodology-2019-highlights-26221/
