Selling a rental property comes with tax implications that can catch real estate investors off guard. Unlike selling a primary residence, capital gains tax cannot be entirely exempted. In this article, we will explore how much tax you can expect to pay when selling a rental property and strategies to defer or minimize these taxes.
Understanding the Taxes Involved
There are two types of taxes you need to consider when selling a rental property: depreciation and recapture tax, and capital gains tax.
Depreciation and Recapture Tax
When you own a rental property, the IRS allows you to depreciate the value of the property over 27.5 years. This depreciation expense helps reduce your taxable net income from the rental property. However, when you sell the property, the IRS wants the depreciation expense returned to them in the form of a depreciation recapture tax.
Capital Gains Tax
The second tax you'll face when selling a rental property is capital gains tax. The amount of tax depends on whether the property was held for a short-term or long-term period. Short-term capital gains are taxed as regular income, while long-term capital gains have specific tax rates based on your taxable income.
Calculating the Taxes Owed
To illustrate the impact of taxes, let's consider a couple of scenarios. In the first scenario, an investor buys and sells a property within six months. In the second scenario, the investor holds the property for two years. The taxes owed in the second scenario are significantly lower due to the long-term capital gains tax rate.
Understanding Property Basis
To determine the amount of capital gain on the sale of a rental property, you need to calculate the property's basis. The basis includes the original purchase price, closing costs, and certain adjustments that increase or decrease the basis.
Items that increase the basis include inspection and appraisal fees, recording fees, real estate commissions, and the cost of improvements. On the other hand, depreciation and certain deductions can decrease the basis.
Minimizing Taxes on Rental Property Sales
While paying taxes is inevitable, there are strategies to minimize or defer the taxes owed on the sale of a rental property.
Primary Residence
Converting your rental property into your primary residence can potentially exempt $250,000 in capital gains if you're single or $500,000 if you're married. However, this strategy requires careful planning, as you must live in the rental property for at least two years to qualify.
Tax Harvesting
Tax harvesting involves offsetting gains from the sale of one investment with losses from the sale of another investment during the same tax year. This strategy allows you to minimize the overall tax liability.
1031 Exchange
The 1031 exchange allows real estate investors to defer paying capital gains tax by reinvesting the proceeds into another investment property. This exchange must meet specific criteria defined by the Internal Revenue Code.
Conclusion
While calculating taxes on the sale of a rental property can be complex, it is possible to minimize the tax burden through careful planning and utilizing strategies like converting to a primary residence, tax harvesting, or a 1031 exchange. Regardless of your approach, it is recommended to consult with a tax professional to ensure compliance with the IRS guidelines and maximize your tax benefits.