Preventing a Tax Hit When Selling Rental Property

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Preventing a Tax Hit When Selling Rental Property

Investing in rental properties may provide investors with consistent income streams that pay their mortgage while also providing them with some additional earnings each month. When such homes are eventually sold, investors stand to profit handsomely. However, these sales might result in hefty long-term capital gains tax penalties.

For example, if you’re married filing jointly and have taxable income between $80,000 and $496,600, the tax rate is 15%. If your taxable income exceeds $496,600, the capital gains rate rises to 20%.

Taxes on profits from the sale of a rental property would equal to $15,000 for a married couple filing jointly with taxable income of $280,000 and capital gains of $100,000. Fortunately, there are strategies to reduce the impact of capital gains taxes. Three of the more successful strategies are described in this article.

Key Takeaways

  • Selling rental properties may provide enormous profits for owners, but it can also result in hefty capital gains tax penalties.
  • If you are married filing jointly and have taxable income between $80,000 and $496,600, the capital gains tax rate is 15%.
  • Tax-loss harvesting, Section 1031 of the tax law, and turning your rental property into your principal place of abode are all ways to reduce capital gains tax.

Offset Gains With Losses

  • What it is:Tax-loss harvesting
  • It is intended for everyone who has capital losses in a particular tax year.
  • What you get: The opportunity to deduct those losses from the capital gains obtained on the sale of a rental property.

The technique of decreasing tax exposure when selling a rental property by combining the profits from the sale with the loss from another investment is referred to as tax-loss harvesting. If an investor holds an investment that has lost value (an unrealized loss) and chooses to sell the asset at a loss in the same year as the gain on rental property sale, this may be a tax planning tactic (a realized loss).Although this tax-saving strategy is usually used to offset profits from stock investments, more people are increasingly using it to offset rental real estate property sales.

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Assume an investor earned $50,000 from the sale of a rental unit in the current fiscal year. They also have a $75,000 unrealized loss in the stock market. To completely offset the $50,000 in capital gains, the investor might opt to sell a part of their holdings for a $50,000 loss.

Take Advantage of Section 1031 of the Tax Code

  • What it is: A “like-kind” transaction under IRS Section 1031.
  • Who it’s for: Anyone who can reinvest the proceeds of rental property sales in new real estate
  • What you get: The ability to defer some or all taxes on the capital gain

Real estate investors may postpone paying capital gains taxes by selling a rental property while acquiring a like-kind property and paying taxes only after the transaction is completed. The phrase “like-kind” has a wide legal definition. An investor does not need to exchange one unit for another or one company for another. Both properties are fair game as long as they are income-generating rental units.

However, time is critical with this technique since investors only have 45 days from the date of a property sale to discover suitable replacement properties, which must be legally closed on within 180 days. Investors must shut even sooner if a tax return is due (with extensions) before the 180-day term. Those who miss the deadline must pay the entire capital gains tax on the initial rental property’s sale.

Leverage Section 121: Primary Residence Exclusion

  • What it is: Conversion of rental property into a primary residence
  • Who it’s for: Anyone able to converta rental property into their primary residence
  • You will receive: The opportunity to deduct up to $500,000 in capital gains taxes
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Selling your primary residence is more tax advantageous than selling a rental property for a profit. Section 121 of the Internal Revenue Code permits individuals to exclude up to $250,000 in profits from the sale of their primary home if they are single, and up to $500,000 if they are married filing jointly. Investors must have resided in their property as their principal home for two of the five years before the sale to qualify. Personal residence years do not have to be consecutive. As a result, some investors decide to convert rental houses into main residences.

The amount of the deduction is determined by how long the property was utilized as a rental vs as a principal home. A taxpayer may also not exclude the part of the gain that was previously due to a depreciation deduction. This is referred regarded as depreciation recapture, and the amount previously claimed as a depreciation deduction is taxed at a recapture rate of 25%.

Rental property sale FAQs

What Happens to Depreciation When You Sell a Rental Property?

Any depreciation claimed for this property on prior tax returns must be reclaimed when you sell it. Consult with your tax expert to see how much you will be required to pay.

What Deductions Can I Claim When I Sell a Rental Property?

There are various deductions that may be claimed when selling a rental property, including transaction charges such as realtor commissions, title fees, advertising fees, and so on. Consult a tax expert to determine the deductions you are allowed to claim.

Can I Avoid Capital Gains Tax on an Inherited Rental Property?

Yes. Any of the three techniques outlined above may help you avoid paying capital gains tax on an inherited rental property. Furthermore, you profit from inheriting it on a stepped-up basis, which means you only pay taxes on any gains beyond fair market value from the date of inheritance, not the initial purchase price.

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If Jane purchases a home for $250,000 in 2000 and sells it for $600,000 in 2021, she will pay capital gains on the $250,000 to $600,000 increase. In other words, since she kept the property for more than a year, she will pay tax on $350,000 of income at the advantageous capital gain rate. According to Gail Rosen, a CPA in Martinsville, N.J., she will also owe a 3.8% net investment tax on the $350,000 in income since her income exceeds $200,000 as a single filer.

If Jane dies before the property is sold, her husband, John, inherits it at the fair market value on the day of Jane’s death, according to Rosen. If the property does not appreciate, when John sells it, his basis will be the same as the sales price, and he will not make a profit. “If the property increases in value to $620,000 when John sells it, he will pay tax on $20,000 at a favorable capital gains rate since inherited property is considered long-term property,” Rosen adds.

The Bottom Line

Capital gains taxes may eat up a large portion of your income from rental property transactions, up to 15% or 20% of your take. Fortunately, capital gains tax avoidance and postponement tactics may alleviate some of the cost. Always seek the guidance of a tax specialist for advice tailored to your individual rental-property situation.

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