Selling a rental property can be exciting and profitable. Whether you are getting ready to cash out on years of hard work, looking to transfer your equity into new investments, or preparing to retire, selling a rental property can be a financial windfall. However, if you aren’t prepared, you might be caught off guard when Uncle Sam takes his considerable share of your profits.
If, like most landlords, you have enjoyed the tax benefits of depreciation over the years, you may be in for a surprise when the IRS hits you with both depreciation recapture and capital gains taxes upon selling your property.
Whether you are trying to reduce your overall tax burden or simply understand your tax liability for effective financial planning, we can take the mystery out of capital gains taxes on rental properties. Here’s what every landlord needs to know about calculating capital gains taxes on the sale of property.
What are Capital Gains Taxes?
A capital gain is the difference between what you paid for an asset (the purchase price) and what you sell it for. When you sell an asset and make a profit, the government expects you to pay back some of those gains in the form of capital gains taxes. The amount of tax you owe is based on your income level and how long you have held the asset. While capital gains taxes apply to all kinds of assets–stocks, bonds, cryptocurrency, and real estate–we will focus specifically on the tax rules surrounding rental properties.
How are Capital Gains Taxes Calculated?
Here is a step-by-step breakdown of calculating the taxes you’ll owe when you sell your rental property. Keep in mind that this is just an overview, and you will want to consult with a tax professional to understand exactly how it will apply in your situation.
1. Calculate Your Cost Basis
The first step is to calculate your cost basis. This is the price you bought the property for, plus any money you spent on capital improvements. Capital improvements can include getting a new roof, adding landscaping, or renovating a kitchen. Subtract any depreciation you’ve claimed over the time you’ve owned the asset.
2. Subtract Your Cost Basis From the Sale Price
Once you have calculated your cost basis, you will subtract your basis from the sale price. The sale price is the amount of money you make selling the property minus any closing costs or realtor commissions.
3. Determine if This is a Short-Term or Long-Term Asset
Your investment will be taxed differently depending on whether it is a short-term or long-term asset. Short-term assets are those that you have held for less than a year. A long-term asset is any asset you’ve had for over 12 months. The IRS taxes long-term assets at a considerably lower rate, so if you can hold onto your rental property for at least a year, it will save you a lot of money in taxes.
4. Take into Account Depreciation Recapture
If you took depreciation deductions while you owned the rental property, the federal government expects to “recapture” those deductions when you sell. Therefore, you will have to pay 25% of the money you deducted in a depreciation tax.
5. Apply Appropriate Tax Rates (Including State Taxes)
Now that you have calculated your taxable capital gain, you have to apply the applicable rate. It is important to note that many states have their own capital gains tax on top of the federal tax. If you are in the top income bracket and you’ve had your rental property for over a year, the federal tax rate is 20%. It is even higher for a short-term rental. California has the highest capital gains tax at an additional 13%. That means California investors may have to pay over 33% in taxes on their capital gains.
What is Depreciation Recapture?
The federal government provides a tax benefit for landlords while they own property, allowing them to deduct the cost of the property over time. This reduces their overall tax liability. However, the IRS expects to be able to recoup those deductions when landlords sell.
When you sell your rental property, you’ll have to calculate the total depreciation deductions you claimed. The IRS then taxes the depreciation at a special rate of 25%, no matter which income tax bracket you are in.
Example
Let’s imagine that you have owned and managed an apartment complex for 10 years. You bought it for $1 million and spent $300,000 on renovations over the last decade. During that time, you claimed $150,000 in depreciation. You would calculate your cost basis like this:
Purchase price + renovations – depreciation = cost basis
$1,000,000 + $300,000 – $150,000 = $1,150,000
After ten years of dealing with renters and handling late-night plumbing emergencies, you decide that you are ready to sell the apartment complex and invest in something less hands-on. You are able to sell the rental properties for $2.5 million. You use a realtor who charges a 6% selling fee, or $150,000. Now you need to calculate your capital gains, and it looks like this:
Sale price – fees – cost basis = capital gains
$2,500,000 – $150,000 – $1,150,000 = $1,200,000
If you are in the highest income bracket and live in California, you will owe around 33% in federal and state capital gains taxes.
Capital gains x capital gains tax rate = capital gains taxes owed
$1,200,000 x .33 = $396,000
You must calculate your depreciation recapture separately.
Deprecation x 25% = deprecation recapture taxes
$150,000 x .25 = $37,500
If you do not take any other actions to reduce or defer your capital gains taxes, you will owe $433,500 in taxes when you sell your rental property.
How to Reduce or Defer Your Capital Gains Taxes
While there is no way to completely avoid paying taxes on the profit you make from selling a rental property, there are things you can do to defer or reduce your taxes owed at the time of sale.
1031 Exchange
If you want to sell a rental property and reinvest in real estate, you can consider a 1031 exchange. A 1031 exchange allows you to defer capital gains taxes when you reinvest your profits back into another qualifying property. However, there are restrictions on what type of property you can invest in, and you must find another property to buy within 180 days of selling your original rental property.
Deferred Sales Trust
An alternative to a 1031 exchange is a Deferred Sales Trust (DST). A DST is a specific type of installment sale that allows landlords to defer capital gains taxes on the sale of their property, spreading their tax payments out over time or even deferring taxes indefinitely. With a DST, you would sell your property to the independent, third-party trust and receive a promissory note in exchange. The trust would then sell your property to the buyer and take possession of your profits.
The trust would then reinvest your profits and repay you in installments as determined beforehand and outlined in the promissory note. You will only owe capital gains taxes on the portion of your proceeds that you receive each year. You can choose to structure interest-only payments from the trust, ensuring that 100% of the capital gains tax remains deferred.
A Deferred Sales Trust can be complicated and must be set up correctly to comply with IRS guidelines, so if you are interested in utilizing a DST, you should reach out to a qualified deferred sales trust trustee.
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Infographic
Selling a rental property can be exciting and profitable. Whether you’re cashing in on years of work or preparing for retirement, it can lead to a significant financial gain. Check out this infographic for a quick guide on calculating the taxes owed when you sell your rental property.
