A recent client of ours owned a rental property in Pacific Beach and was finally at the point of wanting to cash out and rid himself of landlord duties. Our client, Greg, had owned the Pacific Beach or “PB” property since he was in his 30’s and saw many years of positive cash-flow in rental income, but also periods of repairs and damage from bad tenants. Being a coastal “college town,” PB is known for its vibrant nightlife and generally younger crowds. With this, Greg experienced his fair share of problem tenants who used his rental property as their own center for entertainment and parties. Over the years, Greg had replaced the flooring and the roof, costing him around $25,000. He purchased the home for $325,000 and due to a rising market, can actually get $500,000 for it in selling today. While $175,000 in profit sounds wonderful, Greg severely underestimated the hit he would take in taxes from the gain. We created this article to provide a comprehensive breakdown of how capital gains tax works when selling a rental property, and the ways to potentially avoid it.

How is Your Tax Amount Determined?

As with any real estate transaction, you cannot forget to factor in the cost of taxes. For many, real estate covers their largest investments, and there is no exception in paying Uncle Sam taxes on such a transaction.  Generally speaking, your taxis basis is found by calculating your original purchase price, plus the cost of repairs and improvements, minus depreciation deductions you claimed over the years in owning the property.

At a Loss: While selling at a loss is never ideal, there are some favorable rules that will help soften the blow in your time of loss. Here is why this can be a good loss to have: section 1231 losses can be used to cut down any other type of income you have: your salary, any bonuses, capital gains…all of these can be deducted. If your loss is so great that you have a net operating loss or NOL (a loss that exceeds your income), you can roll over or carry back that loss for at least two years. If any NOL is leftover after the two years, you can offset future income for up to 20 years. Keep in mind: you can only claim these losses for the sale of properties used for business or investment purposes.

At a Profit: If you make a profit from your rental property sale, you are subject to paying taxes on the profit. Let’s use Greg’s scenario above to explain how tax basis is determined. He purchased the property for $325,000, invested $25,000 for repairs, but deducted $50,000 over the years in depreciation and can now sell the house for $500,000. His starting basis was $325,000, but his basis at the time of sale is $300,000 ($325,000-$50,000+$25,000). As you can see, his deductions in depreciation reduced his basis, but his improvements to the property increased it. His taxable gain is the sales price minus his adjusted basis ($500,000-$300,000=$200,000).

So, now we know that Greg will be taxed on a gain of $200,000. Breaking this down further: if Greg claimed reductions for depreciation and the repairs ($75,000), he will be held to a higher tax rate of 25%. The rest of the gain, is subject to typical capital gains tax. General capital gains tax for most homeowners is 15%, unless you are in a top tax bracket (in this case, it would be 20%).

Now looking at the gains Greg will be taxed on, you may be beginning to see how severe the implications can be….a whopping $37,500 in this case.

Top 3 Ways to Avoid Capital Gains Tax When You Sell Your Rental Property

At this point, you are likely wondering “how can I avoid paying capital gains tax on my sale!?” Well, there are some loopholes. Depending on your situation, one of these loopholes may just be your savior from paying thousands in taxes.

  1. Offset gains with losses – In other words, tax harvesting, this means that you can offset your gains with losses that took place in other areas of your life or business. Thanks to the Internal Revenue Services, you can pair gains with losses to minimize the amount you’ll owe Uncle Sam. If you took a big hit in the stock market, you can use that loss against your gain and create a “wash.”
  2. 1031 Exchange – Taking advantage of this tax code can be very beneficial, but it isn’t always easy to do. Basically, you can take the proceeds from the sale of your rental property and invest it directly into another asset, avoiding ever having to pay capital gains taxes. With this kind of exchange, the easiest way to avoid gains taxes would be to invest in like-kind replacement property, called a deferred exchange. In other words: if you’re selling one rental property, you would need to invest in another rental property (not a primary residence or vacation home).
    1. Here is where things get tricky: timing with a 1031 exchange. You have less than a year to pull off the exchange. You need to find and commit to the replacement property within 45 days after the sale of your first property, and you must close within 180 days.
  3. Turn Residence into Your Primary – Selling a home that you actually lived in will always yield more mild tax implications. If you are able to move into your rental property, and live in it for at least two years, your gains will be protected up to $250,000 for you ($500,000 if you are married).

As you can see, there are ways to minimize the taxes you pay on the sale of your rental property. But, preparing for the transaction and weighing your options is so important. Sometimes moving into your rental doesn’t sound ideal, or you didn’t intent to reinvest in another piece of rental property…which may have you considering absorbing your capital gains tax. All of this depends on where you are in life, and what makes the most sense for your situation. Regardless of your situation, it is a good idea to consult with your CPA when selling a rental home.

How Working with Experts Can Make Selling a Rental Easy

Navigating through the sale of a rental property can be fuzzy and, at times, downright confusing. Because we encounter complex financial situations every day, our team is capable of helping steer you through your options and the decision. We can make complicated 1031 exchanges make sense for you, and if you have tenants in the property, we can help you address that as well. We look forward to being your resource if you have any questions regarding tax implications of selling, and what options are best for you – feel free to give us a call.

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