Tax Ramifications of Selling a Rental Property
By Nathan A. Bozung, CPA, MST
A common question landlords ask is “How much tax would I owe if I sold my rental property?” Hopefully this article can clear up a few aspects of this scenario, but more than anything the intent is to get the juices flowing and give the conversation a direction to start with.
Depreciation is the way a landlord is permitted to expense a portion of the cost of the rental building itself. Residential real estate is depreciated over 27.5 years, so on a $275,000 home the annual deduction would be $10K. This depreciation deduction is a timing difference – You get a deduction today, but someday when you sell the property you will likely have to pay back depreciation recapture for the amounts you previously expensed. A common misconception I have encountered is that taxpayers think they can choose to not claim depreciation expense in order to avoid paying the depreciation recapture when they sell the property. This is incorrect, as the IRS rules clearly state that you must recapture the greater of the depreciation actually claimed or the depreciation you were eligible to claim. Most depreciation recapture these days on residential real estate is taxed at a 25% Federal tax rate and is technically called “Unrecaptured Section 1250 Gain”, but the tax rates can differ depending on your circumstances.
In an environment of rising prices for real estate, many times a landlord finds themselves in a position where they are selling the property for more than they paid for it. For example, if I bought a house for 200K 10 years ago, and I am selling it today for 300K, I would have a 100K capital gain (I am ignoring depreciation recapture for this example). Long‐term capital (property held more than one year) is taxed by the Internal Revenue Service normally at 15%. However, to the extent your capital gains fit into the bottom two tax brackets you may pay 0% to the Feds. Or if you are in the top tax bracket you get the privilege of paying 20% for your long‐term capital gains. Clearly the timing of a sale of a rental can have a big impact on its resultant tax liability, which most of the time a landlord controls.
Without getting into too much detail, there are a myriad of other potential factors that can affect the taxes related to selling a rental property:
- Primary residence exclusion – You can exclude up to 250K/500K (single/married filing joint) of capital gains if you owned the house and lived in it as your primary residence for at least two out of the last five years. This does not exclude depreciation recapture. And there are further exceptions to the time horizon needed to qualify if you or your spouse are on qualified official extended duty.
- Closing Costs – We’ve ignored closings costs in this discussion thus far, but they typically play a
role in reducing your capital gains and/or depreciation recapture.
- Improvements – Major improvements to a rental property don’t get expensed immediately, but must be capitalized and depreciated over a period of years (it may be 27.5 years, or it may be less, depending on what type of improvement it is). The sale of these improvements have their own different depreciation recapture and capital gain ramifications to consider, though usually they are minor when compared to the home itself.
- Net Investment Income Tax (NIIT) – Still lingering from the Patient Protection and Affordable Care act is the NIIT, which is a 3.8% additional tax on investment income when your overall income exceeds 200K/250K (single/married filing joint). Depending on your circumstances, the sale of your rental property may be considered an investment activity and give rise to this additional 3.8% tax.
- Like‐Kind Exchanges – Many people refer to these as “1031 Exchanges” as they originate from Sec. 1031 of the Internal Revenue Code. They are a way to postpone (not eliminate) taxes from selling a rental property if you are reinvesting the funds from selling your rental into another business use property (rental/investment). You have to use a third party intermediary and follow specific timing rules to qualify, but this can be great a way to kick a large tax can down the road.
- Passive Activity Losses – There are special rules for deducting losses over the years from rental properties. I won’t get into details here, but suffice it to say that sometimes those losses get trapped and carried over into future years. Selling the property they relate to can free up those suspended losses in the year of sale and have an unexpected positive effect on your tax bill.
- State taxes – We didn’t really address state taxes in this discussion so far. State tax rates vary,
but a good rule of thumb to estimate your state tax liability from selling a rental property is
about a 5% tax rate on the same income that you have to pay depreciation recapture and capital
gains tax to the Feds. For reference, Colorado has a flat 4.63% tax rate.
A Changing World
As a reminder the tax world is always evolving, and what may be true today may not remain so
tomorrow. Please do not rely on this article as tax advice. Consult your tax advisor with your specific
situation to get the best answers for you.
Nathan A Bozung CPA LLC
104 South Cascade Avenue, Suite 109
Colorado Springs CO 80903