Note: This post is one in a series of articles produced in collaboration with The Real Estate CPA as part of the Tax Guide series. All corresponding tax articles are here, or download the full Tax Guide [2021 Edition] here.
For many real estate investors, the biggest tax bills will arrive upon the sale of your investment property. This is especially true when all goes according to plan and you’re selling into a strong market while cap rates are low. Take the time now to consider capital gain, depreciation recapture, and 1031 exchange rules before popping the champagne.
Below we discuss what taxes you can expect to pay after the successful sale of a property and how best to mitigate them.
Capital Gains Tax
If you hold your property for less than a year before selling, the IRS dictates you’ll have to pay tax at your ordinary income rates (up to 37%) on the gain.
However, if you hold the property for over a year, your gain will be taxed at the long-term capital gains rate of 15%, or 20% if your income exceeds $434,551 if single or $488,851 if married.
The dark side of depreciation is depreciation recapture, which surfaces upon sale of a depreciated asset.
Depreciation recapture is the portion of your gain attributable to the depreciation you took on your property during prior years of ownership, also known as accumulated depreciation. Depreciation recapture is generally taxed as ordinary income up to a maximum rate of 25%.
Net Investment Income Tax (NIIT)
You’ll also face the Net Investment Income Tax (NIIT) of 3.8% if your income exceeds $200,000 if single or $250,000 if married. While the NIIT applies to both rental income and capital gains, those that closely follow this guide may not report any taxable rental income.
Finally, if you meet the requirements to be considered a real estate professional for tax purposes, your real estate income is not subject to NIIT.
You purchase a rental property in 2011 for $275,000 and later sell it in 2019 for $450,000. Each year your depreciation expense was $10,000 ($275,000 / 27.5) for a total of $80,000 in depreciation over 8 years. This lowered your adjusted basis in the property to $195,000 making your total gain on sale $255,000 ($450,000 – $195,000).
The $80,000 of gain from depreciation is taxed at 25% for a total of $20,000. The remaining gain of $175,000 is taxed at the long-term capital gains rate of 15% for a total of $26,250. Also, because your total income was above $200,000, the entire gain of $255,000 is subject to the 3.8 NIIT for a total of $9,690. When you add this all up, your total tax upon sale is $55,940 or nearly 22% of the total gain. You may also be liable for state taxes, depending on your geography.
Mitigating Taxes Upon Sale with 1031 Exchanges and Other Method
As you can see from the example above, the tax upon sale can be substantial. Luckily, you may have options to defer and/or reduce this tax liability.
Tax Loss Harvesting
In general, capital gains can be offset by capital losses. Tax loss harvesting is simply the selling of capital assets (for example, stocks or other real estate) at a loss to offset your capital gain.
This most likely makes sense if you invested in stock, rental property, or another capital asset with a fair market value that has now fallen below its adjusted basis (purchase price) and is unlikely to recover.
1031 Exchange Rules
1031 Exchanges allow you to defer both the capital gains tax and depreciation recapture from the sale of a property and invest the proceeds into another “like-kind” property, often called “trading up.”
While you ultimately have to pay tax at some point, with the notable exception of inheritance, this allows you defer the tax generated by capital gain and depreciation recapture and use the entire proceeds to purchase a new property, thereby increasing the size of your portfolio at a faster pace than would otherwise be possible if you were paying capital gains taxes upon each sale.
1031 exchanges have a very strict timeline that needs to be followed and generally require the assistance of a qualified intermediary (QI).
Introduced by the Tax Cuts and Jobs Act, Opportunity Funds allow you to defer and reduce capital gains tax from the sale of any capital asset. Unlike a 1031 exchange, you have to redeploy the capital gain only, not the entire sales proceeds.
If you invest the capital gains in an Opportunity Fund within 180 days and hold it for 5 years, you’ll reduce your original taxable capital gain tax liability by 10%. If you hold it for an additional 2 years, the original gain liability is reduced by another 5%. If you then hold your investment for another 3 years, the new capital gain from the Opportunity Fund itself becomes fully tax exempt.
To take full advantage of the tax benefits that Opportunity Funds offer, you’ll need to invest by December 31, 2019. You’ll have to pay tax on the majority of the original capital gain in 2026, regardless of whether or not you continue to hold your investment in the fund.
Opportunity Fund investments made after December 31st, 2019 are not eligible for the full 15% reduction because it is impossible to hold for a full 7 years before 2026.
You purchase a $100,000 property in 2010. In 2019, you sell the property for $200,000 and roll the $100,000 capital gain into an Opportunity Fund within 180 days. In 5 years, your taxable capital gain of $100,000 invested in the Opportunity Fund is reduced by $10,000. And in 7 years it is reduced by another 5%, reducing your original taxable capital gain by a cumulative total of $15,000. This means you will pay capital gains tax on only $85,000 of your original $100,000 gain.
Let’s say you continue to hold the investment for another 3 years. During this time, your $100,000 investment in the Opportunity Fund appreciates to $150,000. Because you held the investment for 10 years, the tax on your $50,000 gain from the Opportunity Fund investment is completely eliminated.
The tax benefit related to reductions in the original capital gains liability is modest at best, so rental property owners will need to carefully weigh the pros and cons of 1031 exchanges versus Opportunity Fund investments. It’s likely that an Opportunity Fund investment will only be preferable to a 1031 exchange for rental property owners when they expect the Opportunity Fund investment to significantly outperform the rental property market over the next 10 years.
An installment sale, sometimes called seller or owner financing, allows you to sell your property to a buyer and receive payments over a predetermined number of years. This spreads out your capital gains tax over several years and gives you an additional return in the form of interest.
You purchase a property in 2011 for $30,000 and want to sell it for $110,000 in 2019. Your AGI is $180,000 and this $80,000 capital gain will increase your AGI to $260,000, causing you to pay an additional 3.8% net investment income tax. Your CPA suggests selling this property using an installment sale to avoid the 3.8% tax.
You find a buyer and sell them the property for $110,000. They put $10,000 down and finance the remaining $100,000 over a period of 10 years, plus 6% interest. Each year, $7,273 out of the $10,000 payment is considered a capital gain and the other $2,727 is your return of principal. You’ll pay $1,091 in capital gains tax but no tax on the return of principal. The interest you receive will be taxed at your ordinary tax rate and you’ll avoid the NIIT in the current year.
Using Cost Segregation to Offset Capital Gains
When you sell a property, current and suspended passive losses can be used to offset the gain from the sale.
If you don’t have enough current or suspended losses to offset this capital gain, you can purchase a new property and use a cost segregation study to create current passive losses that can offset the gain. It’s actually not as complicated as it sounds, so let’s explore an example.
You sell a property for a $100,000 capital gain and have no current or suspended passive losses to help offset the gain. You decide to purchase a new property for $500,000 and have a third-party company perform a cost segregation study. They determine that about 20% ($100,000) of the property can be depreciated using 100% first-year bonus depreciation.
This increase in depreciation expense causes your current losses to exceed $100,000 and allows you to offset the entire capital gain from sale.
Check out more topics on rental property tax deductions:
- Rental Property Accounting Basics
- 9 Common Landlord Tax Deductions
- Business Travel Expenses for Rental Owners
- Pass-Through Deductions and Casualty Losses
- Rental Property Depreciation Overview
- Capital Improvements vs. Repairs and Maintenance Expenses
- Passive Activity Limits and Passive Losses
- Short-Term Rentals and Related Taxes
While reasonable efforts were taken to furnish accurate and up-to-date information, we do not warrant that the information contained in and made available through this guide is 100% accurate, complete, and error-free. We assume no liability or responsibility for any errors or omissions in this guide.