Tax Implications of Selling a Rental Property

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Selling a rental property can have significant tax implications, whether you realize a gain or incur a loss. This article will provide a detailed overview of the various tax considerations involved, including depreciation recapture, selling expenses, and passive loss carryforwards.

Calculating Real Estate Gains or Losses

When you sell a real estate property, or any investment for that matter, you will incur a capital gain or loss. Unless held in a tax-qualified account, the capital gain or loss goes into determining potential tax obligations you may have as a result of the sale.

To determine the capital gain or loss on the sale of a rental property, you need to know the adjusted basis, the sale price, and the selling expenses.

Adjusted Basis: The original purchase price plus capital improvements minus depreciation taken. For details on how to calculate this, see How to Calculate Adjusted Cost Basis for a Rental Property – Gilbert Wealth
Selling Price: The amount for which the property is sold.
Selling Expenses: Costs incurred to sell the property, such as real estate commissions, legal fees, and closing costs.
Passive Loss Carryforwards: Losses that were not deductible in previous years.

Capital Gain or Loss = Selling Price - Selling Expenses - Adjusted Basis - Passive Loss Carryforwards

Example: Capital Gain

Selling price: $300,000
Adjusted basis: $130,000 (after $70,000 depreciation)
Selling expenses: $20,000

$Capital Gain = $300,000 - $130,000 - $20,000 = $150,000$

Example: Capital Loss

Selling price: $200,000
Adjusted basis: $210,000 (after $70,000 depreciation)
Selling expenses: $20,000

$Capital Loss= $200,000 - $210,000 - $20,000 = -$30,000$

Selling Expenses

Selling expenses directly reduce the amount of gain or increase the amount of loss recognized on the sale. These expenses include:

Real estate commissions
Legal fees
Title insurance
Advertising costs
Inspection fees

Selling Expenses

Passive loss carryover refers to the unused portion of passive activity losses (PALs) that cannot be deducted in the current tax year due to the limitations imposed by the IRS. Passive losses, which typically arise from rental real estate activities or businesses in which the taxpayer does not materially participate, can only be deducted against passive income.

If passive losses exceed passive income in a given year, the excess losses are not lost but are carried forward to future tax years. These carryover losses can be used to offset future passive income or can be fully deducted in the year the taxpayer disposes of the entire interest in the passive activity in a taxable transaction. This provision allows taxpayers to eventually benefit from passive losses that exceed current passive income.

Most often these can accumulate in real estate due to a low cash flow property that has a large amount of depreciation.

Calculating Your Tax Liability

When you sell a rental property, there are two ways in which that property will be taxed. It is important to understand and distinguish between capital gains, and depreciation recapture.

Depreciation Recapture

Depreciation is a tax deduction that allows property owners to recover the cost of wear and tear on the property over time. However, when the property is sold, the IRS requires the recapture of the depreciation taken.

The taxation of depreciation recapture is unique. Amounts attributed to depreciation recapture are taxed at your ordinary income tax rates up to a maximum rate of 25%. If your tax rate is 12%, it’ll be taxed at 12%. If your tax rate is 37%, it’ll be taxed at 25%.

In the Capital Gain scenario presented above, the property had $70,000 of accumulated depreciation which is subject to depreciation recapture taxation. The $150,000 total gain is then broken down as $70,000 depreciation recapture and $80,000 capital gains taxation.

Capital Gains

After you’ve accounted for accumulated depreciation, any remaining gain is taxed at capital gains tax rates. Capital gains taxes are separated into short term capital gains and long-term capital gains:

Short Term Capital Gains: Short term gains are gains from investments held less than 1 year. They are taxed at your ordinary income tax rates.
Long Term Capital Gains: Long term gains are gains from investments held more than 1 year. They are favorably taxed at separate tax rates that range from 0% to 20% with an additional net investment income tax that could apply.

See Latest Tax Resources – Gilbert Wealth for the latest tax rates.

In the above example, we determined that $70,000 is from depreciation recapture and $80,000 is capital gains. If your ordinary income tax rates were 22% and capital gains tax rates were 15%, your total tax liability would be $27,400. ($70,000 x 22% plus $80,000 * 15%).

Summary

Selling a rental property involves multiple tax considerations, including depreciation recapture, capital gains or losses, passive loss carryforwards, and selling expenses. Understanding these factors can help property owners manage their tax liabilities effectively and make informed decisions about their real estate investments.

This article is for informational purposes only and does not constitute tax advice. Please consult a tax professional for specific guidance related to your situation.