Taxes Implications When Selling a Rental Property

Did you know that selling a rental property can result in higher taxes compared to selling your primary residence? This difference arises because the IRS classifies rental properties as business investments.

When you sell a rental property, you may be subject to capital gains tax and depreciation recapture. These taxes are designed to reclaim some of the tax benefits you enjoyed while owning the property. 

However, there’s good news: there are strategies available to help you minimize or even avoid these taxes when selling your rental property.

In this article, we will explore everything you need to know about capital gains tax and depreciation recapture. Additionally, we’ll share valuable tips on how to reduce your tax burden when it comes time to sell.

Capital Gains Tax on Property Sales

To better understand what capital gains tax is, let's start by learning what capital gains or losses are. 

Capital gains is classified as the profits you earn when you sell a property. It can be referred to as capital loss if its value is negative. You can calculate your capital gains or losses using this straightforward formula:

Capital Gain/Loss = Sale Price − Tax basis

Tax basis or the adjusted property cost basis refers to the sum of the purchase price, any substantial improvements made to the property, and certain selling costs. However, it's important to note that routine maintenance expenses cannot be included. 

The tax basis can be calculated using the formula below;

Tax Basis = Purchase Price + Improvements + Selling Cost

From the understanding of what capital gains is, capital gains taxes become self-explanatory. Capital gains are subject to taxation because they are treated as rental income according to the Internal Revenue Service (IRS). However, the U.S. Congress has established preferential rates for long-term capital gains, which apply to assets held for more than one year.

Note: You can track both capital improvements and maintenance and repairs using Landlord Studio's property maintenance feature and landlord expense tracking tools.

Short-Term vs. Long-Term Capital Gains

Capital gains can be categorized as either short-term or long-term capital gains.

Short-term capital gains apply to assets held for one year or less and are taxed at ordinary income tax rates, which can be significantly higher.

Long-term capital gains, on the other hand, benefit from reduced tax rates based on your income bracket. As of 2024, these rates are structured as follows:

• 0% for individuals earning up to $47,025 ($94,050 for joint filers)
• 15% for individuals earning between $47,026 and $518,900 ($94,051 to $583,750 for joint filers)
• 20% for individuals earning above $518,900 ($583,750 for joint filers)

This tax structure incentivizes investors to hold onto their assets longer, as the tax burden is lighter on long-term investments.

Primary Residence Exclusion

One important instrument landlords use to reduce capital gains taxes is the primary residence exclusion. 

According to the IRS, homeowners can exclude up to $250,000 of capital gains from taxes if single or up to $500,000 if married and filing jointly. This exclusion applies only if you have owned and lived in the property as your primary residence for at least two of the five years preceding the sale.

Depreciation Recapture Explained

At its core, depreciation recapture involves the IRS collecting taxes on the gain from selling an asset that has previously been depreciated. 

When a taxpayer sells a capital asset—like rental property or equipment—the IRS requires that any profit exceeding the asset's adjusted cost basis be reported as ordinary income. This includes gains that were previously offset by depreciation deductions, which reduce taxable income over time.

The adjusted cost basis of an asset is calculated by taking the original purchase price and subtracting any depreciation deductions claimed during ownership. 

For example, if a property was purchased for $200,000 and $50,000 in depreciation was claimed, the adjusted basis would be $150,000. If the property is then sold for $250,000, the gain of $100,000 would be subject to taxation under depreciation recapture rules.

Depreciation Recapture for Rental Properties

One significant aspect of depreciation recapture is its differential treatment based on asset type. 

For rental properties, the IRS applies specific rules that include capital gains taxes alongside ordinary income tax rates. When a rental property is sold at a profit, part of that profit—specifically the portion attributable to depreciation—is taxed at a higher rate known as "unrecaptured section 1250 gain," which is capped at 25% for 2024.

This means that when calculating taxes on the sale of rental properties, taxpayers must account for two types of gains:

• Ordinary Income Tax: This applies to the portion of the gain that corresponds to depreciation.
• Capital Gains Tax: This applies to any gain beyond the original purchase price after accounting for depreciation.

For instance, if a rental property is sold for $300,000 with an adjusted basis of $200,000 (after $100,000 in depreciation), the total gain would be $100,000. The portion related to depreciation would be taxed at ordinary income rates up to 25%, while any additional gain over and above this would be taxed at capital gains rates.

Calculating Depreciation Recapture

To accurately calculate depreciation recapture for rental properties, follow these steps:

• Determine Cost Basis: Identify the original purchase price of the property.
• Calculate Adjusted Cost Basis: Subtract total depreciation taken from the cost basis.
• Assess Sale Price: Note the final sale price of the property.
• Calculate Gain: Subtract the adjusted cost basis from the sale price to determine total gain.
• Determine Recapture Amount: Compare the total gain with accumulated depreciation; the lesser amount will be treated as depreciation recapture and taxed accordingly.

For example:

• Original Purchase Price: $300,000
• Total Depreciation Taken: $60,000
• Adjusted Cost Basis: $300,000 - $60,000 = $240,000
• Sale Price: $400,000
• Total Gain: $400,000 - $240,000 = $160,000
• Depreciation Recapture: Since accumulated depreciation ($60,000) is less than total gain ($160,000), recapture amount = $60,000.

The remaining gain of $100,000 (i.e., total gain minus recaptured amount) would then be taxed as capital gains.

Strategies to Minimize Tax Burden When Selling

When it comes to selling investments or properties, minimizing your real estate tax burden can significantly enhance your financial outcome. Here are several effective strategies to consider, particularly focusing on capital gains tax reduction.

Offset Gains with Losses: Tax-Loss Harvesting

Tax-loss harvesting is a strategy that allows you to offset capital gains by realizing losses from other investments. This approach is particularly beneficial for those who have experienced losses in their investment portfolio during the same tax year as a property sale.

For instance, if you sell a rental property and realize a capital gain of $50,000, but also have an unrealized loss of $75,000 in stocks, you can sell enough of your stocks to realize a $50,000 loss. This effectively cancels out your capital gains from the property sale, reducing your overall tax liability. 

Utilize Section 1031 of the Tax Code

Another powerful strategy is leveraging IRS Section 1031, which allows for a "like-kind" exchange. This means that if you sell a rental property and reinvest the proceeds into another similar income-generating property, you can defer paying capital gains taxes on the initial sale.

The definition of "like-kind" is broad; it encompasses various types of rental properties as long as they generate income. However, timing is crucial—investors must identify potential replacement properties within 45 days and complete the purchase within 180 days of the sale. Missing these deadlines results in immediate tax liabilities on the original sale.

Convert Rental Property into Primary Residence

Converting a rental property into your primary residence can also yield significant tax benefits. Under IRS Section 121, homeowners can exclude up to $250,000 in capital gains from the sale of their primary residence if single, or up to $500,000 if married and filing jointly. 

To qualify for this exclusion, you must have lived in the property as your main home for at least two of the five years preceding the sale.

This strategy not only provides substantial tax savings but also allows flexibility in how long you utilize the property as a residence versus a rental. However, it’s important to note that any portion of the gain attributable to depreciation deductions taken during its use as a rental will be subject to depreciation recapture at a rate of 25%.

Reinvesting in Opportunity Zones

Investing in Qualified Opportunity Zones (QOZs) offers another avenue for tax minimization. By reinvesting capital gains into designated QOZs, investors can defer taxes on those gains until they sell their QOZ investment or until December 31, 2026—whichever comes first. 

Additionally, if the QOZ investment is held for at least ten years, any additional gains from that investment may be entirely tax-free.

This strategy not only supports economic development in underprivileged areas but also provides substantial tax benefits for savvy investors looking to grow their wealth while minimizing tax liabilities.

How Landlord Studio Helps Prepare for Property Sales

Are you looking for a way to minimize unnecessary taxes when selling your rental properties? Landlord Studio can streamline the preparation process, making it easier to calculate capital gains and manage your financial records effectively.

Simplified Financial Management

Landlord Studio is accounting software designed by landlords for landlords, with automated income tracking, and powerful expense management tools designed to help you maximize deductions and stay on top of your property management.

Track Depreciation

Using Landlord Studio landlords can use the recurring expenses functionality to track and categorize straight-lne depreciation for each property, making it easy to report on your Schedule E at tax time.

Ready-to-Use Financial Reports

Landlord Studio provides ready-to-use financial reports that summarize your income, expenses, and depreciation. These reports simplify the tax filing process and help ensure compliance with IRS requirements, making your life easier during what can often be a complex time.

Create a free account with Landlord Studio today to save money at tax time with software designed for you.