What Will Your Taxes Be On The Sale Of Your Rental Properties?

The idea for many with rental properties is to have a stream of income now and assets to sell when you retire. Many investors are not aware of what the tax consequences will be when they sell the properties and this concerns me because they are likely in for a big surprise.

Capital Gains

There are a couple of components of income taxes when you sell a rental property. Assuming you cannot exclude the gain (have not owned and lived in the property sold as your main home for at least 2 of the last 5 years), then you will be looking at both Capital Gains Tax and Ordinary Income Tax on the sale of the property. The Capital Gains Tax generally is on what you sell the property for less the cost of the sale and less your adjusted basis in the property.

Generally your basis is your cost of acquiring or building the home that you have not deducted previously on your tax returns. You may have additions or reductions of basis for various things which are detailed in IRS publication 523 Selling Your Home.

Hopefully your property will have appreciated in value and you will have to pay the Capital Gains Tax. While no one likes to pay taxes, in this case it is better than not paying the tax because generally that would mean your property decreased in value. The good thing about Capital Gains is the rates are currently favorable to ordinary income tax rates. For example if your ordinary income tax rate in the year of the sale is 0 to 15% then your Capital Gains rate would be 0. Up to the 33% income tax bracket your Capital Gains rate would be just 15%. So you can be happy that you aren't paying higher rates on your gains.

Depreciation Recapture

While most have an expectation for the Capital Gains Tax when they sell their rental property most are not aware of this second component of taxes when you sell your rental properties. When you sell a property that was a rental property you will generally have the recapture of depreciation previous taken, or allowed even if you did not take it as a deduction. This means that the depreciation deduction you get to benefit from every year is taken back when you sell the property and you pay the higher ordinary income tax rates on the depreciation recaptured. So with the depreciation taken it is really like you get to differ income from ordinary income taxes equal to the depreciation taken until you sell the property. That is good news for you now while you own the property from a tax standpoint but eventually you have "pay the piper", that is the IRS later when you sell the property.

The depreciation recapture can be a large tax "hit" for you.  For example if you have taken or were allowed to fully depreciate a $200,000 home (excluding what you paid for the land) over the time you owned the property you will be looking at paying ordinary income taxes on the $200,000 depreciation recapture and if you are in the 33% tax bracket, for example, your tax on the recapture could be $66,000 ($200,000 X 33%).  Ouch.  And it is a double ouch if you are not expecting it...an unexpected $66,000 tax "hit" in retirement can really "throw your plans for a loop."

It is much better to be aware of these tax implications before you sell the property. It is actually best to know about these tax considerations before you invest in the property to begin with so you will know what to expect when you sell the property in retirement.

There are many more circumstances that can affect your tax situation when you sell a rental property, such as if you both owned and lived in the property as your main home for at least two of the last five years. Or if you used the property for business purposes. Your basis is different if you inherit the property, and there are ways to defer the gain on the sale of a rental property but not the depreciation recapture. Again, you can see  IRS publication 523 Selling Your Home for more information about your taxes when you sell your home. Also, you can feel free to contact me to go over the projected tax situation before you sell your home or ideally before you invest in properties. I would be happy to help you understand and prepare for tax considerations and include them in your plans.

Tax Strategy: Plan to Leave to Your Heirs 

Most educated investors with rental homes and commercial real estate plan not to sell their properties themselves but plan to leave it to their heirs.  When a property passes at the death of the owner the heirs who inherit the property get a bump up in basis to the Fair Market Value at the time of death. Technically then the heirs could sell the property at the time of death with no tax consequences in many cases.  If you own investment real estate you may consider holding on to it until death and find other ways to get cash out of it if you need it. In other words the tax hit from ordinary income on the depreciation recapture can be avoided by leaving the rental property to heirs upon your death.

1031 Exchange

The other option is a 1031 exchange for similar property.  This typically won't give you cash but it may enable you to switch properties without the tax consequences of a sale.

Both the 1031 exchange and the tax treatment of real estate upon death will be subjects of coming posts.

The CPA Superhero wants to help you to succeed in business, life, and in retirement.  While my main business is preparing tax returns, I also work with clients helping them oversee their business, accounting, and preparing for the tax implications of the developments in their businesses and personal lives. It can be really complicated with the ever changing conditions in the world. It helps to have a CPA you can regularly talk with to help you with decisions and be prepared for taxes and retirement. Contact me today via email or text to setup an appointment for a phone conversation.

Opportunity Zone Fund (Added 12/31/19)

Now you have a new option for those capital gains. If you invest the capital gains in an Opportunity Zone Fund and potentially delay the tax on the capital gains until 12/31/26. It is complicated but there is more information about this great opportunity here in this post.  

Jeff Haywood, CPA
The CPA Superhero

My posts contain general information that does not fit every situation, they are not all inclusive, and as always for your tax situation everything "depends on facts and circumstances."  In addition, the information/IRS requirements are always subject to change.  So call me to talk about your specific facts and circumstances and what you want to accomplish.

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