Are you thinking of selling a rental property? While selling a primary residence comes with tax exemptions, selling a rental property can be a different story. Tax liabilities can quickly add up and catch real estate investors off guard. In this article, we'll explore how much tax you can expect to pay when selling a rental property and how to minimize your tax obligations.
Understanding Taxes When Selling a Rental Property
There are two main types of taxes you need to consider when selling a rental property. Let's take a closer look at each of them.
Depreciation and Recapture Tax
When you own a residential investment property, the IRS allows you to depreciate the value of the property over a period of 27.5 years. This means that each year, you can deduct a portion of the property's value as depreciation expense.
Depreciation expense is one of the greatest benefits of owning income-producing real estate. It helps reduce your taxable net income from the rental property. However, when you sell the property, the IRS requires you to repay the depreciation expense you benefited from. This is known as the depreciation recapture tax.
Depreciation recapture tax is treated as ordinary income. For example, if you are in the 24% tax bracket, you could owe $916 in depreciation recapture tax for each full year of depreciation.
Capital Gains Tax
The second type of tax you'll pay when selling a rental property is the capital gains tax. This tax is based on the profit or capital gain you make from selling the property. There are two types of capital gains: short-term and long-term.
Short-term capital gains occur when you hold the property for one year or less, such as fix-and-flip investors. They are taxed at your ordinary income tax rate. On the other hand, long-term capital gains occur when you hold the property for more than one year, like most buy-and-hold investors. The tax rates for long-term capital gains in 2021 are 0%, 15%, or 20%, depending on your taxable income.
Calculating Taxes When Selling a Rental Property
To understand how much tax you'll owe when selling a rental property, let's look at some examples.
Example #1: Fix-and-Flip
Suppose you bought a house for $85,000 and sold it for $115,000 after six months. Your capital gain would be $30,000. If you are in the 24% tax bracket, your short-term capital gains tax would amount to $7,200.
Example #2: Buy-and-Hold
Now, let's consider a scenario where you bought a house for $85,000 and sold it for $125,000 after holding it for two years. Again, your capital gain would be $30,000. However, since this is a long-term investment, your capital gains tax would be $4,500 (15% of $30,000).
As you can see, holding the property for a longer period can result in a lower tax burden.
Strategies to Minimize Taxes When Selling a Rental Property
While paying taxes is inevitable, there are strategies you can use to minimize your tax obligations when selling a rental property.
1. Convert to Primary Residence
You can convert your rental property into your primary residence and be exempt from paying tax on a portion of the capital gains. If you are single, you can exclude up to $250,000 in capital gains, and if you are married, you can exclude up to $500,000. However, this strategy requires careful planning and meeting certain criteria set by the IRS.
2. Tax Harvesting
Tax harvesting involves offsetting gains from the sale of one investment with the losses from the sale of another investment in the same tax year. For example, a loss on a stock sale can offset gains from a property sale. This strategy can help reduce your overall tax liability.
3. 1031 Exchange
A 1031 exchange allows real estate investors to defer paying capital gains tax by reinvesting the proceeds from the sale into another investment property. This exchange must meet specific requirements, such as being like-kind real estate and completing the transaction within a specific time frame.
Conclusion
Calculating and minimizing taxes when selling a rental property can be complex, but it doesn't have to be overwhelming. By understanding the different types of taxes involved and implementing strategies to minimize your tax obligations, you can navigate the process more effectively.
Remember, consulting with a tax professional is always a good idea to ensure you're making the most informed decisions when it comes to your rental property investments.