To give you a better idea of what to expect, here is an outline of how rental property sales are taxed, as well as some common strategies investors use to avoid taking a substantial tax hit. This should give you a sense of how selling your rental property will affect your tax bill -- and position you to make that hit as small as possible.
What are the taxes on selling a rental house?
When you sell a rental property, it gets taxed differently than if you were to sell your primary residence. In selling your primary residence, your profits aren't taxable up to a certain point. Beyond that point, however, your profits are treated as capital gains.
The process gets a bit more complicated when you're selling a rental property. In this case, any profit you make on the sale is taxable. Plus, you also need to account for an additional tax: depreciation recapture.
Below is an explanation of how each of these taxes works:
Capital gains tax
There are two kinds of capital gains taxes, and each is taxed differently. The capital gains rate that you'll be subject to will depend on how long you've held the asset in your portfolio.
- Short-term capital gains occur when you've held the asset for less than a year. These gains are taxed in the same way as your ordinary income, meaning that you'd pay the regular income tax for your bracket.
- Long-term capital gains, on the other hand, occur when you've held the asset in your portfolio for more than a year. These gains are given a more favorable tax rate.
Here is a look at the 2020 tax rates:
|Long-Term Capital Gains Tax Rate||Single Filers (Taxable Income)||Married Filing Jointly||Heads of Household||Married Filing Separately|
|0%||$0 - $40,000||$0 - $80,000||$0 -$53,600||$0 - $40,000|
|15%||$40,001 - $441,450||$80,001 - $496,600||$53,601 - $469,050||$40,001 - $248,300|
|20%||Over $441,450||Over $496,600||Over $469,050||Over $248,300|
Finally, be aware that certain high-income taxpayers are also required to pay an additional 3.8% net investment income surtax, regardless of whether their gains are short- or long-term.
The second tax you have to plan for is depreciation recapture. As an investor, you probably already know that, as long as you hold the property in your portfolio, you can write off depreciation as an "expense." However, when you go to sell the property, the Internal Revenue Service (IRS) asks for that money back.
It's easiest to think of depreciation recapture as working similarly to a traditional IRA. In that case, investors are allowed to deduct their contributions on their tax returns. But, once they withdraw the money, it becomes taxable income.
Depreciation recapture works in much the same way. For example, if you held the rental property for five years and wrote off $5,000 for depreciation each year, you would have to pay a depreciation recapture tax on $25,000 after selling.
Keep in mind that depreciation recapture is taxed at your regular income tax rate rather than the more favorable long-term capital gains rate. This is because writing off depreciation as an expense initially allowed you to reduce your taxable rental income.
Additionally, it's important to note that the IRS calculates depreciation recapture based on "allowed or allowable" depreciation, which means you can be subject to the depreciation recapture tax even if you've never taken depreciation as a write-off.
How to offset the tax hit when selling your rental
While you won't be able to avoid paying taxes on your rental property sale entirely, there are some things you can do to soften the blow. Below are some common methods investors use to prevent a major tax hit:
Utilize tax loss harvesting
Put simply, tax loss harvesting involves selling a losing investment in order to generate capital losses, which can then be used to offset any capital gains on your tax return.
The current tax rules allow you to use capital losses to offset an unlimited amount of capital gains. In addition, if your losses are larger than your gains, you can apply up to $3,000 worth (or 1,500, if you're married and filing separately) of those remaining losses against other types of income, including wages and salaries. Any remainder can also be carried over into future tax years.
However, there are a few things to keep in mind if you intend to use this strategy:
- Tax loss harvesting only applies to taxable investment accounts. Accounts like your IRA and 401k allow you to defer paying taxes, so those investments aren't subject to capital gains.
- This strategy can be used for both short-term and long-term gains, but there is a specific sequence to how any losses are applied. Long-term losses are first applied against long-term gains and then against short-term gains. Meanwhile, short-term losses are applied first to short-term gains.
- Finally, you need to pay attention to the wash-sale rule, which states that you cannot use a sale as a loss if you purchase the same security (or a very similar security) within 30 days of the transaction that resulted in the loss. It's there to prevent investors from intentionally creating losses with their investments.
Take advantage of the section 1031 exchange
Also known as a 1031 like-kind exchange, this tax regulation essentially allows the rental property owner to swap one investment property for another on a tax-deferred basis, meaning that any capital gains from the investment will be deferred until you eventually sell the property for cash.
In order to take advantage of this regulation, though, you need to follow certain rules. All the specifics are outlined in IRS section 1031, but here is an overview of what you can expect:
- This exchange can only be used on business or investment assets.
- After the initial property has been sold, you have 45 days to identify the "swap property" you intend to purchase.
- You have 180 days after that point to close on your new property.
- Any cash left over after purchasing the "swap property" is taxable as partial capital gains.
Turn the property into a primary residence
When you sell your primary residence, you're entitled to exclude up to $250,000 worth of profit if you're a single filer and $500,000 if you're married filing jointly. Over the years, this home sale exclusion has led many people to avoid taking a tax hit by converting a rental property into their primary home for a period of time before the sale.
However, like the other strategies above, there are some stipulations. Section 121 will outline them all, and in particular, you'll want to pay special attention to the changes in the tax law that occured in 2009. Here are the most important points:
- The home has to have served as your primary residence for at least two of the last five years.
- A percentage of gains will still be taxable. You can find this percentage by taking the number of years after 2009 that the property served as a rental and dividing that number by the total number of years that you've owned the property.
- You'll still be taxed for depreciation recapture.
The bottom line
The taxes on selling a rental house can get complicated. If you're thinking of selling an investment property, your best bet is to talk to a tax professional, who can walk you through all your options. With their help, you should be able to get a much clearer picture of which tax strategy will be the best fit for you.
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