Owning rental real estate can provide a variety of tax breaks—and the benefits can continue after you put up the “For Sale” sign.
Here is a brief explanation of the tax implications of selling rental property, along with some ways to maximize your profits.
When you sell rental real estate that you’ve owned for more than a year, your profit — the difference between the sales proceeds and basis after reductions for depreciation — is generally considered a capital gain.
However, part of the gain (the amount equal to the depreciation) is taxed at a maximum federal rate of up to 25 percent, rather than the normal 20 percent maximum capital gains rate. Before you complain, remember that the depreciation tax write-offs you took earlier probably sheltered income that would have been taxed at 25 percent or higher. The rest of your gain is taxed at a maximum federal capital gains rate of no more than 20 percent.
Note: The maximum capital gains rate for higher-income taxpayers is now 20 percent (up from 15 percent in 2012). This change only affects single individuals with taxable income above $400,000 (married joint-filing couples with income above $450,000). The capital gains of most individuals are still taxed at a maximum of 15 percent.
You are able to defer income taxes on rental property appreciation until you actually sell. And good properties may generate compounded tax-deferred growth. You can even pocket part of your gain in advance by taking out a second mortgage against your property or refinancing it with a bigger first mortgage.
Another option: You can sell real estate with an installment plan by taking back a note for part of the sale price. Then, your taxable gain can be spread over several years. In addition, you get to charge the buyer interest on the deferred payments, but you generally don’t have to pay interest to the government on your deferred gains. You can’t do this with publicly traded securities!
As we described in our previous article, you generally cannot currently deduct a rental real estate loss if you have an adjusted gross income above $150,000 and you have no passive income. However, you can use the carryover passive losses when you sell. You also get to use them to offset gains from selling your properties. So, it definitely pays to keep careful track of your losses, even if you cannot deduct them during the years you own the property.
Section 1031 Exchanges
Finally, the law allows rental real estate owners to unload appreciated properties while still deferring income taxes indefinitely with a “like-kind exchange,” also known as “Section 1031 Exchange.” Basically, what you do is swap one piece of real estate for another and put off paying taxes until you sell the new piece. And when you are ready to unload the second property, you can arrange yet another like-kind exchange.
Granted, you are not allowed to actually cash in your real estate investments with a Section 1031 Exchange, but you can certainly trade your holdings in one area for properties in what you believe is a more promising location. Or you can, for example, exit the rental apartment business by making a like-kind exchange for a strip shopping center, raw land, or even a golf course or marina for that matter.
What if you sell a rental property at a loss? Although you can’t deduct a loss on a personal residence, a loss on a rental property can potentially be reported on your tax return as an ordinary loss (a so-called “Section 1231 loss”).
Conclusion: Depending on your situation, there are a number of options when you sell rental real estate. Learn more about our real estate experience; then, give us a call.
Convert a Rental Property to Collect Tax-Free Gain
One of the best tax breaks in the law is the federal home sale gain exclusion for personal residences. If you have owned and used the home as your principal home for at least two out of the last five years, you can avoid all federal income tax on the first $250,000 of the gain if you are single or $500,000 if you’re married and file jointly. Depending on your situation, you might be able to pull down up to a half million dollars tax-free!
Unfortunately, this same tax break is not available for rental properties or vacation homes. However, there might be benefit if you are interested in moving. With this strategy, you must convert your rental residence into your principal residence.
First, you sell your current home (and if you qualify, collect up to $250,000 or $500,000 of tax-free gain on that property). Then, you move into the rental home. After living there for a minimum of two years, you can sell that property, which would then be your principal residence, and pocket up to $250,000 tax free if you’re single or up to $500,000 if you’re married and file jointly.
There are no restrictions against claiming the home sale exclusion multiple times, as long as you meet the requirements.