The nice thing about owning a primary residence is that when the time comes to sell you’re exempt from paying capital gains tax (up to a certain amount). Unfortunately, the same thing isn’t true when you sell a rental property.
Tax liability on a rental property sale can quickly add up and catch many real estate investors off guard. In this article, we’ll look at how much tax you can expect to pay when you sell a rental property, and how to defer paying tax when you decide to sell.
Taxes When You Sell a Rental Property
Although there are only two types of taxes you pay when you sell a rental property, they can add up to a surprising amount of money. The truth is that the longer you own your rental property, the larger your tax liability might be.
Depreciation and Recapture Tax
When you own residential investment property, the IRS allows you to depreciate the value of the property (excluding the land) over a period of 27.5 years.
That means if you paid a total of $115,000 for a single-family rental home and the land value was $10,000, your annual depreciation expense would be $3,818 or 3.636% of the property value each year:
- $115,000 total purchase price – $10,000 land value = $105,000 cost basis to depreciate
- $105,000 / 27.5 years = $3,818 annual depreciation expense – or –
- $105,000 x 3.636% = $3,818 annual depreciation expense
If the annual net income from your rental property was $4,500 you could offset that rental income with your $3,818 depreciation expense. Expensing depreciation would reduce the taxable net income from your rental property to just $682. That’s why depreciation expense is one of the biggest benefits of owning income-producing real estate.
However, when you sell your rental property, the IRS wants the depreciation expense that you benefited from returned to them. They do this by collecting a depreciation recapture tax. Recaptured depreciation is treated as normal income, so if you are in the 24% tax bracket, you would owe $916 in depreciation recapture tax for each full year of depreciation:
- $3,818 annual depreciation expense x 24% tax rate = $916
Capital Gains Tax
The second type of tax paid when you sell a rental property is tax on the profit or capital gain. There are actually two types of capital gains, according to the IRS:
- Short-term capital gains occur when property is held for one year or less, as with investors who fix-and-flip real estate. Short-term capital gains are treated as regular income and taxed based on your federal income tax rate.
- Long-term capital gains occur when property is held for more than one year, as with most real estate investors who buy-and-hold rental property. Long-term capital gains tax rates for 2021 are 0%, 15%, or 20%, depending on your taxable income.
Let’s look at two scenarios to see the difference between short-term capital gains tax and long-term capital gains tax.
In the first scenario, the investor buys a house for $85,000 and sells it for $115,000 six months later. In the second scenario, the investor buys a house for $85,000 and sells it for $125,000 after holding it for two years.
In both examples, we’ll assume our investor’s total taxable income is $225,000 married filing jointly. That means he has a 24% federal income tax rate and a 15% capital gain tax rate.
Scenario #1: Fix-and-flip
- Capital gain = $115,000 sales price – $85,000 purchase price = $30,000 capital gain
- Capital gains tax = $30,000 x 24% federal income tax rate = $7,200 short-term capital gains tax
Scenario #1: Buy-and-hold
- Capital gain = $115,000 sales price – $85,000 purchase price = $30,000 capital gain
- Capital gains tax = $30,000 x 15% capital gain tax rate = $4,500 long-term capital gains tax
In the first scenario, our short-term investor made his money faster but paid more in taxes. Because he held the property for one year or less, his net profit after paying capital gains tax was $22,800.
In the second scenario, it took our long-term investor a little bit longer to make his money, but he kept more of it. Because he held the property for more than one year, his taxes were less due to the lower long-term capital gains tax, and his net profit after paying capital gains tax was $25,500.
What Basis is and How it Works
Now let’s look at a more down-to-earth example of how taxes on a rental property work in the real world of real estate investing by talking about how basis works.
The cost basis is the original price paid for your property plus any closing costs that must be capitalized. Basis can be adjusted by increasing or decreasing during the time a rental property is held for investment. When the property is sold, the adjusted basis is used to calculate the amount of capital gain.
Items That Increase Basis
- Inspection and appraisal fees
- Recording fees and owner’s title insurance
- Real estate commission
- Cost of additions or improvements
- Assessments that increase property value
Items That Decrease Basis
- Amount received for granting an easement
- Casualty or theft loss deductions
IRS Publication 551 describes in detail the basis of assets, including cost basis and adjusted basis, for real property.
Example of Taxes When Selling a Rental Property
In this example we’ll adjust the basis to determine the amount of taxes owed when selling a rental property using the following assumptions:
- Purchase price = $150,000
- Sale price = $200,000
- Land value = $15,000
- Closing costs including inspection, appraisal, recording, and owner’s title insurance = $1,500
- Assessment for street repaving = $2,500
- Holding period = 5 years
- Seller total annual income = $225,000
- Seller tax bracket = 24% married filing joint returns
- Seller capital gain tax rate = 15%
In addition, the property owner received $3,000 in exchange for granting an easement to the neighbor whose fence encroached on our owner’s property. This amount decreases the property basis because the encroaching fence effectively reduces the size of the property.
To calculate the taxes owed when selling the rental property we need to make the following calculations:
- Cost basis: $150,000 purchase price + $1,500 closing costs + $2,500 assessment for street paving – $3,000 amount for granting an easement = $151,000
- Value used for depreciation: $151,000 cost basis – $15,000 land value = $136,000
- Depreciation expense: $136,000 / 27.5 years = $4,945 annual depreciation expense x 5 years = $24,725 total depreciation expense
- Adjusted basis: $151,000 – $24,725 depreciation expense = $126,275
- Capital gain on sale: $200,000 sale price – $126,275 adjusted basis = $73,725
- Depreciation recapture tax: $24,725 depreciation expense taken x 24% seller tax bracket = $5,934
- Capital gains tax: $73,725 total gain – $24,725 depreciation recapture = $49,000 x 15% seller capital gain tax rate = $7,350
- Total taxes owed for selling the rental property: $5,934 depreciation recapture tax + $7,350 capital gains tax = $13,284
Depending on the income level and state of residence, investors may also be liable for state and local capital gains tax, and Net Investment Income Tax (NIIT).
How to Sell a Rental Property and Not Pay Taxes
It’s probably safe to say that every real estate investor wants to keep as much profit as legally possible instead of paying taxes. Here are three ways to sell a rental property and (potentially) not pay any taxes:
You can convert your rental property into your primary residence and be exempt from paying tax on $250,000 in capital gains if you are single or $500,000 if you are married. However, this strategy requires a lot of advanced planning, because you’ll need to live in your rental property for at least two years before it qualifies as your primary residence.
Tax harvesting is a strategy used to offset the gains from the sale of one investment with the losses from the sale of another investment during the same tax year. For example, you could use a loss on a stock you sold to offset gains from a property sale.
Or, you may have invested in a joint real estate venture where the cash flow was positive but the net income was negative due to depreciation expense. This loss could also be used to offset the gain from another real estate sale.
Internal Revenue Code Section 1031 permits real estate investors to defer paying capital gains tax when one investment property is sold and another one is purchased within a specific time period:
- Property must be like-kind real estate used for business or investment purposes.
- Different types of like-kind real estate may be exchanged for one another, such as a multifamily property being exchanged for several single-family rental homes.
- Replacement property being purchased must be identified in writing within 45 days of the close of escrow of the relinquished property sold.
- Replacement property must close escrow within 180 days of the close of escrow of the relinquished property.
- A Qualified Intermediary must be used to facilitate the 1031 exchange because investors are not allowed to receive or “touch” their sales proceeds during a 1031 tax-deferred exchange.
Although calculating taxes on the sale of rental property can be complicated, the fact is that it doesn’t have to be. Stessa is a 100% free software for real estate investors that simplifies rental property finances through automated income and expense tracking and smart money management.
By entering the rental property address, linking accounts quickly and securely, real estate investors can generate unlimited reports such as income statements, net cash flow, and capital expense reports. When the time comes to sell, the Stessa Tax Center can help make sure that you’ve been claiming all of the deductions you’re entitled to.