Updated August 6th, 2019
Putting your rental home on the market can be a stressful, time-consuming, and costly process, especially if you're faced with paying a hefty tax bill upon settling the sale.
In an ideal scenario, you'd have the flexibility to hold off on selling your rental property until you qualify for a tax deferment or tax-free capital gains exclusion. As we all know, ideal scenarios rarely work out as planned. From a job relocation to a family emergency, situations often arise that require property investors to sell their rental homes quickly.
If you need to sell a rental property and want to avoid paying taxes on the sale, your best bet is to work with an experienced real estate agent in your local area. Get in touch to learn more and connect with a top-rated, full-service agent for a no-obligation consultation.
In the meantime, we've compiled a comprehensive guide to minimizing and/or avoiding taxes when selling a rental property.
How much tax do you pay when you sell a rental property?
Capital gains tax will typically be the most important tax consideration when selling a rental property. Remember, sellers only need to worry about capital gains tax if they've realized a profit on the sale of their rental property.
How much tax you pay on the sale of a rental home will depend on three factors:
your current income tax bracket, the number of years you've owned the rental property, and your approach to avoiding tax.
What happens to depreciation when you sell a rental property?
In real estate, depreciation refers to the process of using a devalued property to offset your tax obligations. When you sell a rental property, you must use an IRS Schedule D (Form 1040) to report and pay tax on any rental property depreciation deductions you claimed during the time you owned the rental home.
How do you calculate depreciation on a rental property?
While it's always best to consult with a professional tax accountant, we've listed the three basic steps tocalculating depreciation on a rental property:
Record the acquiring price - The acquiring price of your rental home, also known as the basis of your property, is the amount you initially paid to purchase the property. The acquiring price value should also include any fees paid at closing, such as title insurance or transfer taxes.
Calculate basic depreciation - The basic depreciation value is simply the difference between the acquiring price and sale price of your rental property.
Calculate adjusted depreciation - After calculating your rental property's basic depreciation, you'll likely need to adjust for value-altering events, such as renovation expenses, easement grants, utility connection fees, and general repair costs.
Is rental property depreciation tax deductible?
Yes, the IRS allows rental property owners to deduct depreciation over a 27.5-year period. However, if you decide to sell the rental property, you're required to pay a 25% depreciation recapture tax on prior depreciation deductions.
Before you ask, there's no advantage to not claiming rental property depreciation on your tax return - when you sell, the IRS will levy you with depreciation recapture tax regardless of whether you claimed it.
Can you avoid capital gains tax on a rental property?
Yes, rental property owners can employ a wide range of sale and tax strategies to avoid paying capital gains tax. To get you started, we've broken down some of the most common ways to avoid, minimize, or defer capital gains tax.
What is a 1031 Exchange?
A 1031 exchange, also known as a like-kind exchange, is an IRS tax regulation that allows property owners to swap one investment property for another on a tax-deferred basis. In most cases, selling one investment property to buy another would be a taxable sales transaction. However, if a real estate swap meets the condition of a 1031 exchange, any unrealized capital gains on the property sale can be deferred until you sell the asset for cash.
Growing Your Investment Portfolio Using a 1031 Exchange
Savvy property investors can leverage the tax deferment benefits of a 1031 exchange to rapidly expand their investment portfolio. To give you an idea of how you can use a 1031 exchange to up-scale your property portfolio, consider the following example:
Ben purchases a four-family rental property in an appreciating area. In a year's time, local appreciation and somevalue-adding home improvements have led to the property increasing in value by more than $80,000.
At this stage, Ben decides that he wants to sell his four-family rental home to purchase an 18-unit rental property that has just come on the market. By selling the four-family home through a 1031 exchange, Ben can avoid paying close to $20,000 in property taxes.
Because he retained all the profits from the initial four-family home sale, Ben can now afford to make a down payment on the more expensive 18-unit rental property. Without a 1031 exchange, Ben would have had to spend more time saving up a hefty down payment, limiting his potential rental cash flow and preventing him from quickly growing his investment portfolio.
1031 Exchange Rules
IRS Section 1031 encompasses a complex set of real estate procedures and regulations. To help you understand what youcan and can't do during a 1031 exchange, we've listed six key rules to remember:
- A 1031 exchange can only be used for property swaps involving business or investment assets.
- There's no limit on the number of times you can sell and buy business or investment properties through a 1031 exchange.
- In a 1031 exchange, when you close on the initial property sale, you only have 45 days to identify the “swap property” you intend to purchase with the sale proceeds.
- After identifying the “swap property,” you only have 180 days to settle the final purchase transaction.
- Any cash left over after acquiring your secondary property is taxed as partial capital gains proceeds.
- If you sell a depreciable property through a 1031 exchange, special depreciation recapture rules can apply. For more information, check out our in-depth guide to1031 exchange rules in real estate.
Ready to Start a 1031 Exchange?
If you're looking to defer tax on a rental property sale, Clever, through our partnership with 1031 Exchange Advantage, can offer you a 1031 exchange for the discounted cost of $595.Get in touch to schedule a free consultation with 1031 Exchange Advantage today.
Can I move into my rental property to avoid capital gains tax?
Yes, moving into your rental property and converting it to a primary residence is a viable option for reducing your tax liability. This is because the sale of a primary residence can qualify for the capital gains tax exclusion.
Remember, because of congressional and IRS restrictions, the capital gains tax exclusion cannot be used for depreciation related capital gains.
How do you convert a rental property to a primary residence?
If you want to qualify a former rental home for the capital gains tax exclusion, the property will need to meet the following eligibility requirements:
- The property in question must be your primary residence.
- The property in question must not have been purchased through a 1031 exchange in the last five years.
- You must have owned the property in question for over two years.
- Any previous capital gains tax exclusion claims must have occurred over two years prior to the sale of the property in question.
If you've converted your rental home to a primary residence and meet the previously listed requirements, you can exclude up to $250,000 of capital gains as a single filer, or $500,000 of capital gains as joint filers.
What is a monetized installment sale?
A monetized installment sale is a tax treatment category that allows property sellers to use a deferred financing installment contract to postpone capital gains recognition on their home sale.
In a traditional property transaction, when you close on the sale of an appreciated real estate asset, you receive, and subsequently pay tax, on a lump sum of cash.
In a monetized installment sale, the property owner refrains from directly selling to their chosen buyer. Instead, the home is temporarily sold to an intermediary dealer. This property sale is contingent on the dealer reselling the home to your final buyer.
In most cases, you, the property owner, will have already locked in a final buyer prior to selling to the intermediary dealer. After the dealer resells your rental property, you'll receive a principal payment installment contract.
In the meantime, the cash proceeds from the dealer's sale are held in an escrow account. When the escrow account deposit is confirmed, you will receive a limited-recourse, interest-only, no-money-down loan from a third-party lender - this loan is usually worth around 95% of the final buyer's purchase price.
By the time the installment contract is due, the principal payments from the dealer will either equal or exceed the total interest paid on the seller's loan. At this point, the seller's capital gains will be recognized and taxed by the IRS.
What is tax loss harvesting?
Tax loss harvesting, also known as tax-loss selling, is the practice of using the sale of a depreciated asset to partially or completely offset capital gains taxes on another asset sale. In real estate, tax loss harvesting can be used to offset both short-term and long-term capital gains.
How can I avoid tax when selling my rental property?
If you're ready to sell your rental property and want to know more about avoiding tax on the sale, it might be time to discuss your options with a professional. An experienced real estate agent will not only guide you through the ins and outs of listing and selling a rental home - they'll also advise you on the best ways to minimize, defer, or offset your capital gains and property tax obligations.
To connect with a top-rated agent in your local area, get in touch with Clever. Agents in the Clever Partner Network are employed by the largest and most reputable real estate companies and brokerages in the country (e.g. RE/MAX, Century 21, and Keller Williams).
When yousell your home with Clever, you'll enjoy full-service agent support during closing negotiation, low-cost commission rates, and other exclusive cost savings opportunities. The only difference between a Clever Partner Agent and a traditional real estate agent is that all of our Partner Agents have agreed to list and sell your home for a discounted flat fee of $3,000 - or 1% if the home sells for more than $350,000.
Top FAQs About Selling Rental Properties
What happens when you sell a rental property?
Listing and selling a rental property is largely the same as selling your main home. The main difference between a traditional home sale and a rental home sale is that rental property sellers are required to disclose additional investment information to potential buyers, including local tenant demand, typical rental income, and average upkeep costs. After closing on the sale of a rental property, you'll also need to pay or defer any outstanding capital gains and depreciation taxes.
How long do you have to live in your rental to avoid capital gains?
If you have lived in your primary residence for over two years, the IRS will typically allow you to use the capital gains tax exclusion to avoid paying capital gains tax.
Unfortunately, the IRS does not extend the capital gains exclusion to the sale of a secondary residence, such as a rental home. However, if you plan on eventually converting your rental home into your primary residence, there's nothing to stop you from subsequently selling the property at a later date to avoid capital gains - just make sure you're meeting all the tax and ownership requirements!
How are capital gains taxed in 2019?
When you're selling a rental property, there are two main categories of capital gains taxation: short-term capital gains and long-term capital gains.
The short-term capital gains rate applies to investors who have only owned their rental property for one year or less. If this is the case, any capital gains on the sale are assessed as extra income and taxed at your ordinary 2019 income tax rate.
The long-term capital gains tax rate applies to investors who have owned their rental property for more than one year. If this is the case, any capital gains on the sale are taxed at a fixed tax rate of either 0%, 15%, or 20%. The long-term capital gains tax rate you're assessed at will depend on where you fit in the following income brackets:
- 0% when annual income is $0 to $39,375 for single filers, or $0 to $78,750 for joint filers.
- 15% when annual income is $39,376 to $434,550 for single filers, or $78,751 to $488,850 for joint filers.
- 20% when annual income is over $434,551 for single filers, or over $488,851 for joint filers.
Do I need to report rental income?
Yes, if you own a residential rental property, you are expected to report all of your rental income, including weekly rent, advance rent payments, lease cancellation fees, and any other rental expenses paid to you by your tenant. In most cases, rental property owners can use an IRS Schedule E (Form 1040) to report their rental income and rental expenses.