Tax Implications of Selling Your Rental Property: Part 3

With the housing market booming and sellers getting thousands over the asking price, now might be the time to consider selling your rental property. Selling your rental property comes with more considerations than just the selling price. In fact, because of the way rental properties are set up, you may be subject to additional taxes that you need to plan for.

Finding a favorable selling price, determining your cost basis, calculating the taxes, understanding depreciation recapture, and considering a 1031 exchange are the basics you need to comprehend before you sign the final sale document.

Finding a Selling Price

The first step in selling your rental property is determining the price you want to sell. You must consider the cash flow you are currently generating from the property and the price you purchased it for. Cash flow is all the income minus expenses. One way to figure this out is to look at your rental bank statements each month. How do your additions compare to your withdrawals?

Next, uncover how much money you have in the property. This includes the purchase price, renovation costs, and assets placed in service. You don’t want to set a selling price that is below what you have in the property. Moreover, adjust your selling price to account for market demands to ensure you are getting a fair price for your property.

Determining Your Cost Basis

The other half of the equation is your cost basis. When you sell your rental property, you are taxed on the selling price minus your cost basis in the business. For example, let’s say you purchase a property for $200,000 have taken $20,000 depreciation over the years, and put in $30,000 in renovation costs. Your cost basis would be $200,000 + $30,000 - $20,000 to get a total cost basis of $210,000.

Keep in mind your cost basis doesn’t take into consideration the income you generate each year as that has taxes calculated on an annual basis. The higher the cost basis, the lower your expected tax burden will be.

Calculating the Taxes

The taxable amount is based on the selling price minus your cost basis. The taxable amount will first be subject to capital gains taxes. Long-term capital gains are taxed at rates between 0% and 20% based on other factors while short-term capital gains are taxed at ordinary income tax rates. Short-term capital gains are rental properties held for under 12 months.

Ordinary income tax rates can range anywhere from 10% to 37% based on your marginal tax bracket. Each state imposes different ordinary income tax rates, making it a great idea to put together a tax plan before year-end to have a preliminary idea of your upcoming liability.

Higher income taxpayers may also be subject to the net investment income tax which is 3.8% of interest, dividends, and capital gain amounts. This means that for every $100,000 of capital gains tax, you could be paying an extra $3,800 in tax.

Depreciation Recapture

One of the taxes that many rental property owners neglect is depreciation recapture. Each year this “depreciation expense” will reduce the cost basis in your rental property. If you hold the property for long enough, you could end up with a $0 cost basis, hence reducing the taxable amount. The IRS gave you a break via the depreciation expense when you own the property. Once you sell, however, the IRS wants this money back via the depreciation recapture.

The depreciation recapture tax is taxed at ordinary income tax rates since the depreciation you take each year reduces your ordinary income. Let’s say you take $40,000 of depreciation over the past 5 years. The $40,000 of depreciation would be subject to depreciation recapture tax based on your filing status and tax tier.

Even if you don’t claim depreciation for your rental each year, the IRS will still assess a depreciation recapture tax based on the amount they believe you should have taken. This is important to keep in mind to ensure you are taking the tax-reducing deduction each year and avoid getting hit with a large tax bill when you sell your rental property.

1031 Exchange

Taxes aren’t avoidable forever, but they can be deferred for a long period of time. When you sell a rental property, you have the option to defer the tax bill if you purchase another qualifying property within a specified time frame. For example, let’s say you are looking to buy a vacation rental and sell one of your other rental properties. If you complete the transaction within the specified time period, you can defer your tax burden. There is no limit on how many 1031 exchanges you can engage in, making it a great solution for many investors who frequently purchase new properties.

The exchange can only take place with like-kind properties, meaning a rental for a rental or a primary home for a primary home. The proceeds from the sale of the property are held in escrow until you find a new property to purchase. The entire transaction is generally nontaxable unless you sell one depreciable property for another type. In this instance, you may be required to pay depreciation recapture taxes on the property.

Let’s Look at an Example

Going through an example of a rental property sale can help you piece together the taxes you can expect to pay when you sell your real estate. Let’s say you paid $200,000 to purchase a rental property. The land was assessed at $50,000 and the dwelling at $150,000. For simplification purposes, depreciation was taken at $5,000 per year and you are in the 24% tax bracket for federal purposes and a 15% tax bracket for long-term capital gains.

You have the property for 5 years and sell it at $250,000. This creates a $50,000 capital gains tax ($250,000 - $200,000), resulting in a tax liability of $7,500. Over the 5-year period, you reduced your income by $25,000 of depreciation, resulting in a depreciation recapture tax of $6,000. Assuming you are subject to the net investment income tax, you will pay $13,500 in taxes when you sell the property.

Summary

Selling your rental real estate property comes with taxes that you may need to plan ahead for. The last thing you want is to be hit with an unexpected tax bill that you can’t afford to pay. Uncovering your expected tax burden can be done through a tax projection, which takes into consideration the other items on your tax return.

Having a professional piece this document together is advised to obtain the most accurate numbers, making it important to contact a professional. A professional will likely have worked with various clients on the tax implications of selling their rental property.

You’ve work hard to create ultimate real estate portfolio, don’t lose it to taxes!