Selling a rental property can create a much larger tax liability than when you sell your primary residence. That’s because the IRS views your rental property as a business investment and will try to recapture some of the benefits you received during the time you owned your income property.
Fortunately, there are several ways to minimize and even avoid paying tax when you sell a rental property.
Taxes Rental Property Investors Need to Pay
When you sell a rental property, you need to pay tax on the profit (or gain) that you realize. The IRS taxes the profit you made selling your rental property two different ways:
- Capital gains tax rate of 0%, 15%, or 20% depending on filing status and taxable income
- Depreciation recapture tax rate of 25%
To calculate your gain, subtract the adjusted basis of your property at the time of sale from the sales price your rental property sold for, including sales expenses such as legal fees and sales commissions paid. Then, separate your gain due to depreciation recapture from the capital gain to determine the total amount of tax owed.
How to Adjust the Basis of a Rental Property
Adjusting the basis of your rental property decreases the amount of tax owed when you sell.
The original basis is the price you paid for the property plus any improvement. But basis can also increase or decrease during the time you own the property. Here are some of the most common ways to adjust the basis of your rental property:
1. Increase basis
Increasing the basis of your rental property reduces the amount of taxable capital gains. Generally speaking, anything that adds value to your property (and that can not be treated as a routine repair or maintenance) can be added to the basis:
- Add an addition or improvement such as a new roof, room addition, or adding a new room
- Money spent to restore the property to habitable condition after a natural disaster such as a flood or hurricane
- Cost of adding or extending utility service onto the property, such as extending the main water line to the rental unit or installing a new septic system if your property is in a rural area
- Assessments levied by the city for improvements such as installing a curb or paving the street in front of your rental property
- Legal fees such as preparing the purchase contract, deed preparation, or perfecting the title by removing a hidden lien at the time you purchased the rental property
- Escrow fees and closing costs including title search and recording fees, owner’s title insurance, and transfer taxes
2. Decrease basis
There are also items that can decrease the basis of your rental property – and potentially increase the amount of capital gains tax due:
- Depreciation subtracted from your net income during the time you owned the rental property must also be subtracted from the basis, which is how the IRS “recaptures” depreciation
- Money you received for granting an easement on your property, such as allowing the utility company to extend service to your neighbor
- Insurance payment received as reimbursement for a theft or casualty loss on your property, such as a ground-mounted HVAC stolen from your backyard
- Section 179 deduction taken to deduct personal property used in your rental property, such as appliances, flooring and window coverings
Example of adjusting rental property basis
Now let’s look at an example of how the basis of a rental property can be increased and decreased. The odds are you’ll never experience all of these situations in your real estate business, but it’s good to see how the pieces for adjusting basis can fit together:
- At the time of purchase: Rental property purchased for $100,000 + escrow legal fees of $3,000 + immediate capital improvement of $10,000
- During the 10-year ownership period: City replaced water lines for an assessment of $4,000 + easement granted to the next-door neighbor for building their fence on your side of the property line $1,000 + total depreciation expense of $41,090
- At the time of sale: Rental property sold for $134,400 including selling expenses
When you purchased the property, your basis was $113,000 (purchase price + escrow related fees + improvements). During the 10 years you owned the property, the city assessment increased your rental property basis, while the easement you granted and the depreciation expense decreased the basis:
- Initial basis = $113,000
- Increase to basis = $4,000 for city assessment for new water lines that increased the value of your property
- Decrease to basis = $1,000 for easement to neighbor + $41,090 total depreciation expense over 10 years
- Adjusted basis = $113,000 + $4,000 – $1,000 - $41,090 = $74,910
- Property sales price (including expenses) = $134,400
To calculate the capital gain and capital gains tax liability, subtract your adjusted basis from the sales price of the property, then multiply by the applicable long-term capital gains tax rate:
- Capital gain = $134,400 sales price - $74,910 adjusted basis = $59,490 gains subject to tax
Married people filing jointly usually pay a capital gains tax rate of 15% (or 20% in the top tax bracket), while depreciation recapture is taxed at 25%:
- $41,090 depreciation recapture x 25% = $10,272.50
- $18,400 remaining capital gain x 15% = $2,760
- Total tax liability = $13,032.50
That’s more than $13,000 you’ll have to give to the government, and that amount doesn’t even include any additional taxes your state might collect.
How to Minimize Rental Property Taxes When You Sell
There are numerous benefits to owning income-producing real estate, including recurring cash flow, long-term appreciation in market value, and reducing your taxable net income with ownership, business, and depreciation deductions.
However, as we’ve seen from the above example, when the time comes to sell your rental property you may be in for a surprisingly large tax bill. As seasoned real estate investors know, what the IRS gives they’ll eventually try to take back.
Fortunately, there are four ways to reduce the amount of taxes you owe when selling a rental property:1. Tax-loss harvesting
Offsetting the gain from one transaction with the loss from another is known as tax-loss harvesting. This tax reduction strategy is frequently used by stock market investors, but you can also use it with rental property.
For example, if you had a taxable gain of $60,000 from selling a rental property but can sell money-losing stocks for a loss of $50,000, you can reduce your taxable gain to just $10,000. If you have more losses than gains, you can carry-forward $3,000 each year to offset your ordinary income on federal income taxes.
2. Installment sale
If you own the property free and clear (without any mortgage) you can also use an installment sale to reduce the amount of tax owed when you sell the rental property. With this strategy, you still pay tax, but the payments are spread out over a longer period of time.
Also known as a seller carryback or a seller-financed loan, an installment sale allows you to only pay taxes on the portion of the gain related to each payment you receive from your buyer. Any interest you receive from the buyer is treated as income.
Depending on the purchase price and how your installment sale is structured, the profits from the sale may more than offset the amount of capital gains from each installment sale payment.
3. 1031 tax-deferred exchange
Of course, not every real estate investor has sizable losses in the stock market or wants to run the risk of making an installment sale, only to have to take the property back if the buyer defaults.
An IRS Section 1031 tax-deferred like-kind exchange is the perfect tool to use to defer your taxes on capital gains. The rules of a 1031 exchange allow you to sell or relinquish one (or more) income properties and replace it with another, while completely deferring the payment of any capital gains tax generated:
- Relinquished and replacement properties must be used for business or investment purposes.
- Real estate must be like-kind but can be a different asset class, such as exchanging a commercial property for a residential property.
- Replacement property must be of equal or greater value than the relinquished property.
- All of the sales proceeds must be reinvested to avoid receiving taxable “boot.”
- Name on the title of the replacement property must be the same as the name on the title of the relinquished property.
- Replacement property must be identified within 45 days of the sale of the relinquished property.
- Replacement property must be purchased within 180 days of the sale of the relinquished property.
4. Convert rental property into a primary residence
The IRS doesn’t allow you to use your primary residence in a 1031 exchange.
However, there is a way to convert your rental property into your primary residence and profit from the exclusion of capital gains tax on a primary residence offered under the tax law:
- Rental property must actually be your primary residence for tax purposes, rather than a second home or vacation property.
- Rental property must not have been purchased through a 1031 exchange within the preceding five years.
- Rental property must be owned by you for at least two years.
IRS Section 121 allows you to exclude up to $250,000 in profits from the sale of your primary residence if you use a single filing status, and up to $500,000 in profits if you are married filing jointly.
If you use this strategy to reduce the amount of tax from the sale of a rental property, be sure to speak with your financial advisor, because the amount of deduction varies based on how long the property was used as a rental versus your primary residence.