Virtually every taxpayer understands that selling rental real estate falls under entirely different taxation rules than your primary residence – but there’s a lot more to the equation than knowing you’ll potentially owe for capital gains.
Here are 10 lesser-known tax considerations for selling rental property you’ll want to think about before putting yours on the market.
You will need to calculate your adjusted basis
Determining your capital gain is not as simple as subtracting the purchase price from the sale price.
The basic formula for calculating your adjusted basis is:
ADJUSTED BASIS = PURCHASE PRICE + QUALIFYING CLOSING COSTS + CAPITAL IMPROVEMENTS – DEPRECIATION – OTHER DEDUCTIONS
- Note: Special rules and/or assessments may apply, particularly if you inherited or received the property as a gift.
Not all long-term capital gain is taxed equally
For most taxpayers, the long-term capital gains rate is 15% – but if your taxable income exceeds the 15% threshold, the rate rises to 20%.
If your taxable income is below the threshold, but your capital gain exceeds the 15% long-term capital gains rate bracket, you will pay 15% on a portion of the gain and 20% on the remainder.
- Note: Other capital gains/losses realized during the tax year could impact the rate you pay on the sale of your rental.
Short-term capital gains rates may apply
If you sell a rental property that you have owned for less than one year, any capital gain will be taxed at your ordinary income rate.
Depreciation recapture is mandatory and taxed at your ordinary income rate
A common mistake owners make when calculating the potential proceeds from the sale of a rental property is not to account for depreciation recapture.
When a rental property is sold, the full allowable depreciation over the time the taxpayer owned the property is “recaptured” by the IRS – and taxed at your ordinary income tax rate (up to a maximum of 25%.)
This happens whether you did or did not take the depreciation deduction in previous years.
Let’s look at a simple example:
Say you have $100,000 in capital gain (sale price – adjusted basis) from the sale of your rental property and the total allowable depreciation over the time you owned this real estate is $40,000. You will pay your ordinary income tax rate on the $40,000 (or 25%, whichever is smaller) and then the appropriate long-term capital gains rate on the remaining $60,000 (15% or 20%, depending on your taxable income.)
- Note: If you did not take the depreciation deduction in the past, you may be able to file amended returns for some of those years.
There are ways to spread the gain over multiple tax years
Structuring the sale with installments can potentially reduce your tax burden, depending on future taxable income, additional capital gains and losses you have planned during the current and future tax years, and other factors.
You can offset the capital gain on your rental sale with other capital losses
Timing a capital loss with your rental real estate sale can lower your total capital gain and decrease your tax burden.
Take care to not confuse pre-sale repairs and capital improvements
Investments made in improving the property prior to sale can be used to decrease your tax liability – but it is important to categorize these investments appropriately as tax treatment for pre-sale repairs and capital improvements are different.
In the eyes of the IRS:
- Pre-sale repairs restore the property to its original condition and can be expensed as part of your selling costs.
- Capital improvements enhance value or extend the useful life of the property and are added to your adjusted basis.
Don’t forget about state taxes
Depending on your state’s tax laws, you may be subject to additional capital gains taxes or depreciation recapture.
Net Investment Income Tax (NIIT) may apply
If your modified adjusted gross income (MAGI) exceeds certain thresholds, you may be subject to an extra 3.8% tax on the capital gain.
- NIIT is only imposed on the lower of your net investment income or the amount by which your MAGI exceeds the threshold
- NIIT is not imposed on the portion of the gain attributed to depreciation recapture
You may be able to defer taxes altogether using a 1031 exchange
A 1031 exchange allows you to defer capital gains taxes by reinvesting the proceeds from a property sale into a qualifying like-kind property.
Understand that this strategy involves complex rules, tight deadlines, and limited reinvestment options.
- Note: A 1031 exchange does not eliminate the tax liability but defers it until the new qualifying property is sold and not rolled into a new 1031 exchange.
Developing a tax minimization plan with your CPA
From determining the optimal timing for selling your property to restructuring the terms of your sale, accurately accounting for expenses and improvements, maximizing available deductions, and taking your full tax picture into account, working with a CPA before you list your rental could save you tens of thousands of dollars or prevent major tax consequences.
