Introduction
Selling a rental property can have significant tax implications for property owners. In this blog post, we will explore:
- how sales of rental properties are taxed
- differentiate between short-term and long-term capital gains
- discuss the concepts of depreciation and depreciation recapture
- emphasize the importance of documenting selling expenses, and
- introduce the concept of Section 1031 Exchanges.
The Primary Residence Exclusion Will Not Apply
The profit made from the sale of a rental property will almost always be taxable.
When the real estate being sold is the taxpayer’s primary residence, the primary residence exclusion allows homeowners to exclude a portion of the gains from the sale of their primary residence, if they meet the eligibility criteria. This exclusion is up to $250,000 for single filers and $500,000 for couples married filing jointing. However, this provision requires that the property must have been the taxpayer’s primary residence for two out of the last five years. Because a rental property is not a primary residence, the sale of real estate used as an investment does not meet this requirement.
In very rare circumstances, a taxpayer may live in a home for two or more years, move to another home and rent out their former primary residence, and then sell the former residence within three years. That timeframe may allow the taxpayer to exclude a portion of their gain from taxation. A qualified tax practitioner can assist in determining what portion of the profit is excludable.
Capital Gains
In the last section, we established that profits made from selling rental properties are taxable. Generally, the profit from the sale of a rental real property is a capital gain (see Depreciation Recapture below). The capital gains tax is the levy on the profit that an investor makes when an investment is sold. This distinction is important because investments held for longer than one year are taxed at preferential rates.
The classification of capital gains as either short-term or long-term is determined by the holding period of the asset. If the property is held for one year or less before selling, it is considered a short-term capital gain. Short-term capital gains are taxed at the taxpayer’s ordinary income tax rates. On the other hand, if the property is held for more than one year, it qualifies as a long-term capital gain. Long-term capital gains generally benefit from preferential tax rates, which are lower than ordinary income tax rates.
Capital gains tax rates vary depending on the taxpayer’s income and filing status. As of the current tax year, there are three main tax brackets for long-term capital gains: 0%, 15%, and 20%. The rate applied depends on the taxpayer’s taxable income.
| 2023 Long-Term Capital Gains Tax Rates | ||
| Taxable Income | Rate | |
| Single | Married Filing Jointly | |
| Up to $44,625 | Up to $89,250 | 0% |
| $44,626 to $492,300 | $89,251 to $553,850 | 15% |
| Over $492,300 | Over $553,850 | 20% |
Depreciation Recapture
When operating a rental property, the owner is allowed to claim depreciation deductions on the property. Depreciation spreads the cost of an asset over its expected lifespan. This is attractive because it lowers the taxable income earned from the property.
However, when selling a rental property, the depreciation claimed over the years can trigger depreciation recapture.
Depreciation recapture requires the taxpayer to pay taxes on the accumulated depreciation at the higher rate of up to 25%, rather than the capital gains rate. Accumulated depreciation is the sum of all depreciation claimed on tax returns from the first year the property was rented to the year it was sold. The rationale behind depreciation recapture is that while you have been able to deduct the depreciation expenses from your taxable income over time, the IRS wants to ensure that you pay taxes on the portion of the property’s value that was depreciated.
Depreciation recapture is limited to the smaller of the realized gain on the sale or the accumulated depreciation of the asset. In other words, if the amount of accumulated depreciation is higher than the gain from the sale, you only include the realized gain in the recapture calculation.
It’s important to note that not all rental property sales trigger depreciation recapture. If you sell your property at a loss, there is no recapture since there is no gain to be taxed. Additionally, if you engage in a like-kind exchange under Section 1031 of the Internal Revenue Code, you can defer the recapture tax by rolling over the gain into a new qualifying property.
Section 1031 Exchanges
Section 1031 of the Internal Revenue Code provides an opportunity for rental property owners to defer capital gains taxes by engaging in a like-kind exchange. This exchange allows the taxpayer to reinvest the proceeds from the sale of the rental property into another qualifying property, deferring the tax liability until a future sale. Understanding the rules and requirements of Section 1031 Exchanges can provide a valuable tax planning strategy for rental property owners. To learn more, check out our post on Section 1031 Exchanges.
Caution: Impact of Cost Segregations
Cost segregation is a process of identifying assets that are personal property that can be depreciated more quickly than their corresponding real property. While residential rental buildings must be depreciated over 27.5 years, assets like wiring, flooring, plumbing, appliances, fixtures, and air conditioners can be depreciated in just 5 to 7 years. By capturing depreciation earlier in the life of the property, owners can free up cash and use it for their operating and investment needs now.
Cost segregation is a powerful tax planning tool, as we discussed in a previous blog post. When selling a rental property that was depreciated using a cost segregation study, however, depreciation previously taken on non-real estate assets such as wiring will be recaptured as ordinary income. Furthermore, those assets cannot be part of a Section 1031 Exchange. So, while cost segregations can be a great option for tax deferment, it is important to be aware of the potential impact on the tax created by the sale of the property. A qualified tax professional can help you determine the tax consequences of your particular circumstances.
Selling Expenses
To accurately calculate the gains from selling a rental property, it is crucial to document all relevant selling expenses. This includes expenses such as renovations, repairs, realtor commissions, advertising costs, and closing costs. Proper documentation can save thousands of dollars in taxes.
Conclusion
Selling a rental property has significant tax consequences that every property owner should be aware of. Rental properties do not qualify for the primary residence exclusion, and depreciation recapture can impact the tax liability upon selling. Understanding the concepts of depreciation, capital gains rates, and deductible selling expenses is crucial for accurately reporting the transaction and minimizing tax liability.
For those looking to continue investing in real estate, exploring the possibilities offered by Section 1031 Exchanges can provide a valuable tax deferral strategy.
By staying informed and understanding the tax implications of selling a rental property, you can make informed decisions, maximize tax benefits, and ensure compliance with applicable tax laws. Selling a rental property can be a complex process, but with the right knowledge and guidance, you can navigate the tax consequences and make the most of your investment endeavors.
