Selling a rental property can be complicated. Find out how you can eliminate some of the tax burden.
While owning a rental property is a long-term investment, there may come a time when you want to sell. Perhaps your retirement plans are to get out of the owner occupier business altogether. Or maybe you've found a better investment opportunity that will give you a higher annual return than your current rental property offers. Regardless of the reason or timing, it's important to consider estate sales tax and plan an exit strategy and reduce sales tax exposure.
Depending on where you live and where the property is located, you will pay capital gains or state income tax on the proceeds of the sale. In addition, accumulated depreciation is recaptured and taxed at a federal rate of 25%.
What is Recaptured Depreciation?
Recaptured depreciation is taxed when you sell your lease.
There are tax advantages to owning a rental property. As a homeowner, you can deduct expenses including property taxes, living expenses, insurance premiums, mortgage interest, travel expenses, and interest and fees paid on borrowed funds used for home improvements. You can also take advantage of the property depreciation deduction each year. Imagine taking an annual deduction for an investment that is likely to appreciate rather than depreciate. Unfortunately, the depreciation tax deduction must be taken back when you sell.
Tax-Advantaged Ways to Sell a Rental Property
Offsetting Your Taxes There are profitable ways to sell your rental property and reduce, avoid, or defer taxes that you would otherwise owe. Here are four tax ways to sell a rental property that may work for your situation.
1. Offset Gains With Losses
Known as “tax loss harvesting,” you can offset gains against other investment losses. Let's say, for example, that you've been holding an undervalued stock. You bought 1,000 shares at $25/share and they are now selling for $5/share. Sell the stock and that $20,000 loss can offset the $20,000 gain on the sale of your rental property.
This strategy works with both long term and short term losses. You can use capital losses to offset an unlimited amount of capital gains under the current tax code.
However, there are some caveats.
- First, there is a certain order in which your losses can be applied to your winnings. Long-term losses are first applied to long-term gains and then applied to short-term gains. And vice versa.
- Second, you cannot use the sale of the property as a loss if you buy similar property within 30 days of the sale that resulted in the loss. This no-no falls under the “wash sale rule,” which prohibits investors from intentionally causing losses with their investments.
- Also remember that tax loss harvesting only applies to taxable investment accounts. Tax-free retirement accounts are not subject to capital gains or income taxes; you already defer taxes on qualified accounts like 401(k)s and IRAs.
2. Take Advantage of a 1031 Exchange
1031 Exchange With a properly executed 1031 exchange, you can legally defer paying investment gains taxes when you sell a qualified property to purchase a “like” property. As long as your earnings are reinvested in a similar real estate asset (and you follow all the rules), the capital gains tax on your debt can be deferred or reinvested in the new property.
The big idea here is that you are simply exchanging one investment for another. All profits are locked in the property exchanged. Therefore, no tax benefit or loss is recognized or claimed on the income or capital gain.
Named after the section of the tax code in which it appears, there are many rules involved in the proper execution of the 1031 exchange rule;
- You need a qualified broker to handle your buying and selling transactions.
- You have 45 days after the sale of the rental property to identify a replacement property.
- Close on the replacement property within 180 days of closing on the relinquished property.
- Both properties involved in a 1031 exchange must be investment properties that generate
- income or are expected to appreciate.
- The full purchase price of the “like-kind” replacement property must be equal to or greater than the full net sale price of the relinquished property.
- All principal proceeds from the sale must be used to purchase a replacement property. Or you have to pay capital gains on money that is not used for that specific purpose.
3. Convert Your Rental Property Into Your Primary Residence
Buying a house with a friend as an investment Although less common for practical reasons, this is a viable strategy for avoiding capital gains taxes when you rent out real estate.
As defined by the IRS tax code, the proceeds from the sale of your principal residence are exempt from capital gains tax up to $250,000 if you are single and $500,000 if you are married filing jointly.
To qualify, the taxpayer must have owned and occupied the property as a principal residence for two of the five years immediately preceding the sale. However, ownership and residency do not have to be concurrent, as long as you have lived in the property as your primary residence for at least 24 of the past 60 months, the income qualifies for tax-exempt status.
There are, of course, rules that must be followed. For example, you can usually only claim this exemption once every two years and must pay income tax on any part of the residential property that is not used for residential purposes.
However, if this arrangement is attractive given your current lifestyle, such as downsizing your pension, moving your rental property is a great strategy to legally avoid paying tax on your gains.
4. Sell Your Rental via an Installment Sale
Sale of Investment Property In detail in Publication 537, the IRS allows taxpayers to defer a portion of the proceeds from the sale of investment property under an installment sale agreement. In installment sales, the sales proceeds are divided into multiple payments rather than a lump sum. This allows the taxpayer to spread the proceeds over several tax years, reducing what is owed at the time of sale.
Spreading income over several years can be particularly beneficial for a taxpayer who wishes to:
Withhold income at the desired tax rate
- Keep capital gains income in a lower tax bracket
- Avoid or reduce the impact of the alternative minimum tax, higher Medicare Part B premiums,
- net investment income and other taxable events.
With an installment sale, you agree to sell the rental property to the buyer in installments over time. At least one payment must be received within one year after the tax year of the sale; you must report this as a credit sale on IRS Form 6562.
I recently did an installment sale on one of my rental properties. My long-term tenant, who took care of the house and always paid his rent on time, indicated that he was interested in buying the house if he ever wanted to sell it.
In November, he received a $155,000 insurance settlement and wanted to use it to buy the house. The current market value is $180,000. You paid $155,000 at closing and signed a promissory note to pay an additional $25,000 plus interest in monthly payments over the next 5 years. This reduced my 2020 taxable income by $25,000.
Of course, it's a bit more complicated than that, as there are some tedious rules to follow. But the general idea is that you use installment sales to spread the proceeds of the sale over time, reducing the amount of tax you pay.
Selling a rental property can be complicated. Generally, you will have to pay capital gains taxes or income taxes on the earnings. In addition, you must pay a 25% tax on all recaptured depreciation.
It is best to consult an experienced real estate tax attorney and local real estate agent (preferably one with investment experience) for assistance. Choose professionals who listen to understand your unique situation and provide you with the best options based on your investment goals and current tax situation.