Tax Consequences of Selling a Rental Property, Part 1

Whether you are considering buying an investment property, or you have many in your portfolio, understanding the tax implications of selling rentals can save thousands of dollars.

When you sell an investment property you pay capital gains tax on the amount you profited and on the depreciation you took. Below is a simple format for calculating your taxable amounts. First you find out your cost basis-

Purchase Price………………………300,000
Depreciation………………………..- 20,000
Improvements…………………….. + 5,000
Cost Basis………………………..=285,000

Then you can figure out your taxable gain-

Sales Price………………………….. 400,000
Selling Costs……………………….. -25,000
Cost Basis…………………………. -285,000
Taxable Gain………………………. =90,000

The first time I sold a rental “depreciation recapture” took me by surprise. The great benefit we reap from depreciating rental properties each tax year comes back to haunt us when we sell. Taxes are typically a painful 25% on the amount depreciated. The capital gains taxes on the remaining $70,000 (taxable gain less depreciation) are usually 5% or 15%, depending on your tax bracket. An average taxpayer is looking at $15,000+ in taxes on this sale.

If you”d like to avoid paying these taxes (wouldn’t we all) you have to make this property qualify for the IRS’s primary residence exclusion. It’s not always an option, but it’s a great tax strategy if you can make it work. When you sell your primary home, you can profit up to $250,000 ($500,000 if married), and not owe taxes. If during the five year period ending when you sell your rental house, you lived in it for at least two years then you qualify for the exclusion. It doesn’t matter which two years you live in the property. You can convert a rental to a primary residence or a primary residence to a rental, and take advantage of this great tax break. Although you will still have to pay taxes on the depreciation recapture.

If you don’t qualify for the primary residence exclusion you can delay taxes by buying another rental. The sale of your current rental and the purchase of the replacement rental must comply with several strict IRS rules. I’ll cover this topic in my next blog posting.

Tax laws and tax rates change regularly. Always do your homework and then consult a tax advisor.

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