Taxes have a habit of making things complicated.
Selling a rental property comes with a few extra tax complications when compared to selling a house or primary residence. Unlike a home, a rental property generates income, which makes it a business investment in the eyes of the IRS. They see a liability, and before you know it, you’re handing them far more cash than you’d expected.
However, knowing the ins and outs of these fees will help you to save money or even avoid paying them altogether. It’s time to talk taxes and shed some light on how much tax you’ll need to pay when selling a rental property.
Types of Rental Property Taxes
Before diving right into those money-saving loopholes, it’s important to understand the types of taxes you’ll be faced with paying. Here’s a brief rundown.
Selling a rental property means forking over a sum of money based on the profit you earned from the sale. That profit is called your gain, and the IRS collects it through either a depreciation recapture tax or through a capital gains tax.
Calculating your total amount owed is a matter of crunching some numbers. Simply subtract your property’s basis at the time of sale from the amount you sold it for. Once you’ve separated your gain rate from depreciation recapture (25%) and capital gain (anywhere from 0% to 20% based on filing status and taxable income), you’ll have your final number. Unless, of course, you decide to…
Adjust the Basis of Your Rental Property to Decrease Taxes Owed
One of the easiest ways to avoid taxes when selling a rental property is to adjust its basis. The basis is the original amount you paid for the property, plus any new bells and whistles you’ve added since buying it. By adjusting that number, you can make your property less taxable and, as a result, keep a bit of extra cash in your pocket. Here’s how you can make it happen:
Raising your property’s basis will, counterintuitively, lower the number of taxable capital gains the IRS can sink its teeth into. The basis can be raised by adding value to your property. This can be accomplished by renovating or improving your property in some way; installing new rooms/additions or replacing your roof are both common examples. You can also make utility improvements or add new paved areas outside the building.
While some changes to your property can raise your basis, others will decrease it. This runs the risk of increasing your capital gains tax. Seemingly simple things, including easements on your property, insurance payments received for theft committed on your property, and even the use of personal appliances on the premises can send your basis number plummeting.
How to Minimize Taxes When Selling a Rental Property
Adjusting your basis to cut back on taxes is certainly a wise avenue to go down. But what if adding new rooms and renovating your roof isn’t an option? What if additions and utility improvements aren’t in your budget, or you simply don’t have the time to make those changes before the sale? If that’s the case, fear not: there are still ways to reduce taxes when selling a rental property. Here are a few.
When one transaction experiences a loss, investors often offset that loss with the gain of a more successful transaction. This practice – common in the stock market – is called tax-loss harvesting, and it’s a great way to save you some funds. If, for example, your property sale produces a taxable gain of $40,000, you can sell $20,000 in stocks to cut your gain in half. If you play your cards right, you could even sell enough stock to carry forward and actually earn money.
Utilize Section 1031 of the Tax Code
Using stocks to save on taxes isn’t a solution for every seller. Perhaps you don’t have that kind of money to withdrawal, or you might not have any stock market investments at all. If that sounds like you, Section 1031 of the IRS tax code might pique your interest. This helpful chunk of US tax law allows you to sell or relinquish income properties and replace them with new ones. This then defers any capital gain tax payments to the new property. In order for this trick to work, the replacement property must be:
- used for business or investment purposes
- priced at equal or greater value than the first property
- identified within 25 days of the first property’s sale
- purchased within 1080 days of the sale
If all of these boxes are checked, Section 1031 might be the option for you.
Convert Rental Property into Primary Residence
Another helpful trick for reducing tax costs for rental property sales is to rechristen those properties as residential. Specifically, if you convert the property into a primary residence, you can eliminate the added expenditures of a property gains tax. If you can prove to the IRS that the property you’re selling is your actual primary residence (and not a second or vacation home), and that you’ve owned it for two years and didn’t purchase it using the 1031 exchange (which isn’t applicable for primary residences), this loophole might come in handy.
However, converting your rental property into a primary residence also hinges on the “2 out of 5-Year Rule.” This stipulation states that, if you’ve used and owned a property as a primary residence for an aggregated two-year chunk of a five-year period ending on the date of the property’s sale, you’ll have met the requirements for tax exclusion. This method of money saving requires a bit more preparation and time than some others, but if you qualify, it could save you in the long run.
Rental Properties in Columbus, OH
If you’re ready to move forward with your commercial real estate sale, talk to the experts at DRK. Our team is ready to answer questions, provide tips and guide you through the buying (and money-saving) process.
Scouting new real estate to buy? Take a look at the rental properties available in the Columbus, Ohio, area.
Until next time,
Other blog posts you may enjoy:
Buying Commercial Real Estate Checklist
Benefits of Leasing Office Space