Content of the material
- Tax Evasions Vs. Tax Avoidance When Selling A Rental Property
- Recapture Taxes
- Sell The Company, Not The Real Estate
- Can I Avoid Capital Gains Tax on an Inherited Rental Property?
- Capital gains tax varies by residential status
- Taxes on selling a second home
- Taxes on selling a vacation property
- Taxes on selling a rental house
- Selling a rental property that was a primary residence
- How to Avoid Paying Capital Gains Tax on Rental Property
- Tax Rates
Tax Evasions Vs. Tax Avoidance When Selling A Rental Property
Evasion and avoidance are two very different things.
Tax evasion is very illegal. You can’t get away with anything else if life and business, but not tax evasion. Sooner or later they will get you.
There are many complex strategies that asset protection firms will try to sell you to evade taxes. Often they can soak up more of your profits than the taxes, and you can still get caught. It’s generally not worth it.
Fortunately, legal tax minimization and avoidance are perfectly legal. It can be far simpler. It is even expected by taxing authorities and lawmakers. They design these taxes with these exceptions so that you don’t have to pay too much. They expect you to use them. If you don’t you are just making supersized donations to organizations that probably don’t need your money.
So, don’t evade. Do avoid.
Agents Compete, You Win.
The IRS also taxes you for depreciation that you claimed when your property sells for more than its depreciated basis. To calculate its depreciated basis, subtract all of the depreciation that you wrote off while you owned the property from the adjusted cost basis. If you sold for more than your adjusted cost basis, all of the accumulated depreciation is taxable. If you sold for less than your adjusted cost basis, but more that your depreciated basis, the difference between the two would be taxable. In either case, the tax rate on depreciation recapture is 25 percent. Because it’s a type of capital gain, it would also be subject to the Medicare recapture tax if you have to pay that, as well.
Sell The Company, Not The Real Estate
As with all of these potential tax saving ideas, be sure to talk to your own accountant and tax expert to assess the real benefits for you in your unique situation. Some may find that if they hold properties in an LLC or other corporate entity that they can sell shares in that business and pay less in taxes than just selling the underlying asset.
Can I Avoid Capital Gains Tax on an Inherited Rental Property?
Yes. You can avoid paying capital gains tax on an inherited rental property through any of the three methods listed above. Additionally, you benefit by inheriting it on a stepped-up basis, meaning that you only pay on any gains over fair market value from the date of inheritance, not the original purchase price of the property.
If Jane buys a property for $250,000 in 2000 and sells it for $600,000 in 2021, she will pay capital gains on the increase from $250,000 to $600,000. In other words, she will pay tax on $350,000 of income at the favorable capital gain rate because she held the property for more than one year. Additionally, she will owe a 3.8% net investment tax on the $350,000 of income because her income is more than $200,000 as a single filer, according to Gail Rosen, a CPA in Martinsville, N.J.
If Jane dies before the property is sold, the current law states that John inherits the property at the fair market value on the date of Jane’s death, Rosen points out. If the property does not appreciate, when John sells the property, his basis in the property would be the same as the sales price, and he would not have any profit. “If the property appreciated to $620,000 when John sells, he would pay tax on $20,000 at favorable capital gains rate since inherited property is considered long-term property,” Rosen says.
Capital gains tax varies by residential status
As mentioned earlier, when selling a primary residence — the home the owner lives in on a day-to-day basis — many sellers are exempt from capital gains taxes. This assumes sellers have made this their primary residence for a minimum of two out of the past five years, and their gain (or profit) on the home is less than $250,000 for single filers or $500,000 for married-filing-jointly filers.
When it comes to second properties, capital gains tax liability can vary based on whether your home was a vacation property or a rental property.
Taxes on selling a second home
Unlike your primary home, which is typically exempt from capital gains taxes (with a few exceptions detailed later), the IRS considers a second home a “personal capital asset.” You must file a Schedule D with your Form 1040 on your taxes for the year you sell, reporting the sale of your second home. Here are a few more things you need to know:
- Selling a second home is similar to selling stock: You’ll be taxed on the profits of the sale in the same way you are when you sell other assets, like shares of stock.
- If you own the home for more than a year, you’ll pay long-term capital gains taxes, and the tax rate depends on your income — more on that later.
- If you own the property for less than a year, you’ll pay short-term capital gains taxes, and the rate is the same as your ordinary income-tax rate. For most taxpayers, it’s advantageous to wait at least a year after purchasing a second home before selling.
Taxes on selling a vacation property
If you’re selling a vacation home that you haven’t ever rented out, the taxation will be similar to that of a second home. The taxes will be calculated based on the sale price, less what you paid for the property (your tax basis). Just like a second home, the tax rate will be based on whether the property was held for more or less than a year. The IRS considers a vacation home a “personal capital asset.”
Taxes on selling a rental house
Rental houses typically qualify for some deductions and write-offs, but it’s important to talk to your tax professional. Here are a few key differences between selling a rental property and a vacation home.
- If you’ve been deducting depreciation on your rental property on your tax return every year to offset the tax you pay on rental income, it’s important to remember that those write-offs reduce your adjusted basis, increasing your taxable gain when it comes time to sell.
- Any suspended tax losses (i.e., when your rental income is lower than your total rental property deductions) that were disallowed due to income limitations are deductible in the year the property is sold, regardless of those income limitations in that year.
- If you previously lived in the home as a primary residence or second home prior to it becoming a rental property, your adjusted tax basis becomes significantly more complicated, and you should seek the advice of a tax professional to determine your gain basis and your loss basis.
- If you’re planning on purchasing another rental property after selling your current property, you may be able to opt for a Section 1031 exchange. More on that shortly.
Selling a rental property that was a primary residence
Did you know? If you live in a property at least one day out of the year, you can designate it as your principal residence.
If the property was ever your primary residence, only a portion of the capital gain is taxable.
If you own a property for 10 years and lived in it for four years, then 40% (4/10) of the gain is eliminated. So the taxable capital income in our example becomes $25,000 instead of $42,500.
There’s also a unique “one-plus rule” that increases your savings even more. Usually only one home can be your principal residence each year. This rule allows you to sell a home and buy a home in the same year, while having them both designated as your primary residence.
Designating a property as your primary residence can be complicated – please consult with an accountant to investigate further.
How to Avoid Paying Capital Gains Tax on Rental Property
Every real estate investor wants to make as much as possible from buying, selling, and renting properties. If you sell a rental property, you stand to lose a substantial amount of money by paying capital gains tax, especially if you’re in the high earner tax bracket. You could be hit with a tax bill that could put a 20% dent in your profits.
For those looking to reduce the tax burden and sell rental properties without paying tax, there are methods you can employ to avoid paying capital gains tax when you sell your property. There are 3 main options:
1. 1031 Real Estate Exchange
One popular option for real estate investors is to reinvest the profits generated by the sale of one rental property to fund another acquisition. A 1031 real estate exchange enables you to roll the proceeds of one sale into a similar investment opportunity. If you choose to pursue this avenue, you’ll negotiate the terms of the sale of your rental property, and ownership will then be transferred to an appointed intermediary. The intermediary will then sell the property, receive the payment and hold it on your behalf until you have identified a suitable property to buy and you’re ready to complete the purchase. The intermediary will then release the funds and oversee the purchase for you. The 1031 exchange enables you to buy new rental properties without paying capital gains or depreciation recapture taxes. These fees will be deferred until you sell a rental property without investing in another. This is an excellent option for investors who are looking to expand their real estate portfolio, as a 1031 exchange may be used on any number of properties.
Before you consider a 1031 real estate exchange for your rental property, it’s crucial to understand the qualifying criteria and stipulations. This type of exchange can only be used under certain circumstances, and there are rules governing its use. These are outlined below:
● Properties involved in a 1031 real estate exchange must be used for investment or business purposes only.
● The new property must be classified as ‘of like kind.’ ● An approved, independent intermediary must be appointed. You cannot act as an intermediary for yourself.
● Once your property is sold, you have 45 days to identify new properties and the exchange must be completed within 180 days.
● You must clearly state your intentions in writing when identifying new properties, providing details of the property, which should be submitted to and signed by your intermediary or the owner of the house you plan to purchase. You can identify up to three properties, or any number of properties, provided that the total market value doesn’t exceed 200% of the fee for which you sold your property.
● Any funds that are left over from the sale of your property and not used to fund a new purchase are liable for taxation, so it’s best to search for a property of equal or higher value.
It is important to note that the term ‘of like kind’ is relatively loose when talking about real estate. If you’re selling a condo, for example, you don’t have to buy a new condo, and you could easily swap a townhome for a house. Timing is crucial with this option. You have 45 days after closing the sale of your property to identify potential new properties in writing, and you must close within 180 days. If the tax year is due to end before the 180-day period elapses, you’ll need to push for a rapid exchange. If you miss the deadline, you’ll be liable to pay capital gains tax on the rental property you sold.
The terms of a 1031 exchange are laid out under IRS Section 1031.
2. Offsetting property gains with losses
Also known as tax loss harvesting, this option can be beneficial for anyone who has capital losses within the same tax year. If you’ve generated a profit on your rental property, and you choose to sell, you can offset this profit against losses you may have incurred through alternative investments. This is a technique that is often used by investors who profit from stocks and shares, but it can also be useful for real estate investment. The arrangement works because the IRS enables you to pair profits and losses to calculate the total amount of tax you owe. To illustrate this concept, imagine you made a profit on a rental property, but you lost more money on stocks within the tax year. In this scenario, you could offset the profits against the loss, reducing the amount of tax you owe.
3. Using your rental property as a primary residence
Another tactic that can be used to reduce taxes on the sale of a rental property is using your rental home as a primary residence. When you sell a home as a homeowner, the tax liabilities are much less substantial than selling a rental property for profit. This means that it can be beneficial to convert a rental property into a primary residence before you sell. IRS Section 121 states that you can exclude up to $250,000 from the profit of primary residence property sales if you are single, and $500,000 if you are married and have owned the property for at least 5 years. To qualify, you must have lived in the residence for a minimum of 2 years. The amount you can deduct will depend on how long you’ve owned the property, and how long you’ve used it as your primary residence. If you bought a house for $200,000 and rented it out for 3 years before living in it for 2 years, for example, you could deduct 40% of the capital gains tax incurred on the profit. If the house sold for $300,000, for example, this means that you would be liable to pay capital gains tax on $60,000, rather than $100,000.
The bad news if you have a gain is that the depreciation (ordinary) portion of the gain is taxed at a higher rate than the price appreciation because you received a deduction against income each year for the amount of depreciation, thus saving taxes equal to the depreciation times the income rate. In 2012, the capital gain is taxed at 10 or 15 percent for long-term gains (property held one year or more), depending on your tax bracket. Short-term capital gains on property held for less than one year and the depreciation portion of long-term gains are taxed as ordinary income, based on your tax bracket.