Investing in rental property can be a smart financial move. For starters, you can enjoy years of cash flow while the rent you collect pays your mortgage and builds your equity.
There are also many tax benefits. For example, you can deduct mortgage interest, property taxes, depreciation, insurance, repairs, maintenance, and other costs associated with operating the rental. And when it's time to sell, you could end up with a tidy profit, especially if you're in a hot real estate market.
Of course, the IRS will want its share of your good fortune. Depending on your situation, you could be on the hook for capital gains and depreciation recapture taxes. Here's a quick look at the tax implications of selling an investment property -- and how you can lessen the hit.
You can exclude up to $250,000 of gains ($500,000 if you're married filing jointly) if
- the house is your primary home,
- you lived in the house for at least two of the previous five years, and
- you owned the house for at least two of the last five years.
As a real estate investor, you probably won't qualify for the exclusion. That means you'll likely owe capital gains tax on the entire profit. The amount you pay depends on how long you held the investment.
How much you owe depends on how long you owned the property:
- Less than a year: It's a short-term gain, taxed as ordinary income (up to 37%).
- More than a year: It's a long-term gain, taxed at 0%, 15%, or 20%, depending on your income and filing status.
If you're a higher-income taxpayer, you may also owe a 3.8% net investment income tax.
If you own rental property, one of the deductions you can take is for depreciation. In general, rental property is depreciated over 27.5 years -- the "useful life" of the property. So, you can deduct 3.636% of your cost basis each year for 27.5 years.
For example, if your cost basis is $200,000, you can deduct $7,272 ($200,000 multiplied by 3.636%) each year. If you're in the 24% tax bracket, that would save you $1,745 a year in taxes.
You keep depreciating the property for up to 27.5 years or until you take the property out of service, whichever comes first.
While the depreciation deduction is valuable, the IRS remembers the deductions you took. When you sell the property, they'll want some of the money back in the form of depreciation recapture tax.
The tax applies to the part of the gain that's attributable to the depreciation deductions you've already taken. Depreciation recapture is based on your ordinary income tax rate -- capped at 25%. You report it on IRS Form 4797, Sales of Business Property.
Don't think you can get out of paying the depreciation recapture tax by not deducting depreciation on your taxes. You'll owe taxes on the depreciable amount -- whether you claimed the deduction or not.
Still, depreciation recapture won't apply if you sell an investment property for a loss. If you owned the property for at least a year, the loss is considered a Section 1231 loss, and you can use it to lower your tax liability for the year. Otherwise, you can carry back the loss to offset the previous two years of taxable income or carry it forward to offset future income for up to 20 years.
Many investors use a strategy to defer paying capital gains taxes when they sell an investment property. It's called a 1031 exchange, or a like-kind exchange. You can use it when you sell one property and buy another "like-kind" property with the proceeds. In the process, you defer paying capital gains and depreciation recapture taxes.
To qualify as a 1031 exchange, the transaction must meet three conditions:
- The replacement property must be like-kind.
- You must pay tax on any "boot" -- the fair market value of cash, benefits, or other property you receive that's not like-kind.
- You must identify the replacement like-kind property within 45 days of selling the first property and buy it within 180 days.
You report a 1031 exchange using Form 8824, Like-Kind Exchanges when you file your income tax return.
Make a plan to reduce taxes on the sale of your investment property
Capital gains and depreciation taxes can take a big bite out of your investment profits. However, you can use a 1031 exchange to defer taxes on both, leaving more money in your pocket for your next investment.
Real estate tax laws are complicated and change periodically. It's always a good idea to work with a trusted tax professional who can ensure your investment strategy makes good financial sense.