How to Decrease Your Tax Burden When Selling a Rental Property
Selling a rental property can be complicated. Find out how to potentially eliminate some of the tax burdens.
While owning rental real estate 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 landlord business altogether. Or maybe you’ve found a better investment opportunity that’ll provide higher annual gains than your current rental property is providing. Regardless of reason or timing, it’s important to take under consideration the tax on the sale of property and plan an exit strategy to lessen the tax hit on the sale.
Depending on where you live and where the property is located, you will either pay capital gains or state income tax on your gains from the sale. Additionally, accumulated depreciation is recaptured and taxed at a federal rate of 25%.
What is Recaptured Depreciation?
Recaptured Depreciation is Taxed When You Sell Your Rental.
There are tax advantages to owning rental real estate. As a homeowner, you can deduct expenses including property taxes, maintenance expenses, insurance premiums, mortgage interest, travel costs, and interest and fees paid on borrowed funds used to improve the home. You can also take advantage of a property depreciation deduction each year. Imagine that, taking an annual deduction on an investment that’s likely appreciating in value, not depreciating! Unfortunately, the depreciation tax deduction needs to be recaptured when you sell.
Tax-Advantaged Ways to Sell a Rental Property
There are advantageous ways to sell a rental property and lessen, avoid, or defer the taxes you would otherwise owe. Here are four tax-advantaged ways to sell a rental property that could work for your situation.
1. Offset Gains With Losses
Referred to as “tax loss harvesting,” you can offset the gains with other investing losses. Let’s say, for example, that you’ve been holding onto a stock that has lost value. You bought 1,000 shares at $25/share and they’re now trading at $5/share. Sell the shares and that $20,000 loss can offset $20,000 gains on your rental property sale.
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.
There are some caveats, however.
- First, there’s a specific order in which your losses can be applied to gains. Long-term losses are applied against long-term gains first and then to short-term gains. And vice versa.
- Second, you can’t use a property sale as a loss if you purchase a 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 creating losses with their investments.
- Remember too that tax-loss harvesting only applies to taxable investment accounts. Non-taxable retirement accounts aren’t subject to capital gains or income taxes — you’re already deferring taxes on qualified accounts like 401(k)s and IRAs.
2. Take Advantage of a 1031 Exchange
Through a properly executed 1031 exchange, you can legally delay paying taxes on investment gains when you sell a qualified property to purchase a “like-kind” property. As long as your gains are reinvested in a similar real estate asset (and you follow all the rules), the capital gains tax you would owe can be deferred or rolled over into the new property.
The big idea here is that you are merely exchanging one investment for another. All of the gain is locked up in the exchanged property. So, no gain or loss is recognized or claimed for income or capital gains taxes.
Named after the section of the tax code in which it appears, there are a lot of rules involved in properly executing under the 1031 exchange rule:
- You need a qualified intermediary to handle both the sale and purchase transactions.
- You have 45 days following the sale of the relinquished rental property to identify the replacement property.
- Close on the replacement property within 180 days after the closing on the relinquished property.
- Both properties involved in the 1031 exchange must be investment properties that generate income or are expected to increase in value.
- The total purchase price of the replacement “like-kind” property must be equal to, or greater than, the total net sales price of the relinquished property.
- All the equity received from the sale must be used to acquire the replacement property. Or you must pay capital gains of the amount not used for that express purpose.
3. Convert Your Rental Property Into Your Primary Residence
While less common for practical reasons, this is a viable strategy to avoid capital gains taxes when you sell a rental property.
As defined in the IRS tax code, the proceeds from selling your primary residence are exempt from capital gains tax on all profits up to $250,000 if you’re single and $500,000 if you’re married and filing jointly.
To qualify, a taxpayer must own and occupy the property as a principal residence for two of the five years immediately before the sale. However, the ownership and occupancy do not need to be concurrent so as long as you’ve lived in the property as your primary residence for at least 24 of the last 60 months, the gains qualify for the tax exemption.
There are, of course, rules to follow. For example, you can generally only claim this exclusion once every two years and you must pay taxes on the gain on any portion of a residential property that wasn’t used for residential purposes.
Nevertheless, if this arrangement is attractive given your current lifestyle, like downsizing in retirement, moving into your rental property is an excellent strategy to legally avoid paying taxes on your gain.
4. Sell Your Rental via an Installment Sale
Detailed in Publication 537, the IRS allows taxpayers to defer a portion of the gains on the sale of an investment property with an installment sales agreement. In an installment sale, the proceeds of the sale are broken down into multiple payments instead of one lump sum. This allows the taxpayer to spread the gains over multiple tax years, reducing what’s due at the time of the sale.
Spreading the income over multiple years can be particularly advantageous for the taxpayer who wants to:
- Keep income in a desired tax rate bracket
- Keep capital gains income within a lower tax bracket
- Avoid or lessen the impact of the alternative minimum tax, higher Medicare Part B premiums, net investment income, and other taxable events.
I recently did an installment sale on one of my rentals. My long-term tenant — who treated the home like she owned it and always paid rent on time — indicated she was interested in buying the home if I ever wanted to sell.
In November, she received an insurance payout of $155,000 and wanted to use it to buy the home. The current market value was $180,000. She paid $155,000 at closing and signed a note to repay the additional $25,000 plus interest in monthly installments over the next 5 years. This reduced my taxable gains by $25,000.
Of course, it’s a little more complicated than that as there are some tedious rules to follow. But the general idea is that you use an installment sale to spread the income from the sale over time reducing the amount of tax owed.
Further Reading: How to invest in Commercial Real Estate
Selling a rental property can be complicated. Generally, you will owe either capital gains tax or income tax on the gains. On top of that, you will owe a tax of 25% on all recaptured depreciation.
It’s best to consult with a knowledgeable real estate tax attorney and a local realtor (preferably one with investing experience) to help you. Choose professionals who listen to understand your particular situation, and provide you with the best options based on your investing goals and current tax situation.