A property’s appreciation is an increase in its value. When you invest in a rental property, you pay income taxes on its appreciation only when you sell the property. The amount of appreciation on which you pay income taxes is called the capital gain. Your capital gain typically differs from your property’s actual price appreciation due to certain costs and tax deductions that you must factor into the calculation. Capital gain equals the property’s adjusted selling price minus its adjusted basis and is typically taxed at lower rates than ordinary income.
Add a rental property’s purchase price to the amount of closing costs you paid when you bought it. Closing costs include items such as recording fees and brokerage commissions. For example, assume you paid $200,000 for a rental property and $15,000 in closing costs. Add $200,000 to $15,000 to get $215,000.Step 2
Add to your result the amount of money you spent on capital improvements, which are additions or enhancements that extend the property’s life or increase its value. Capital improvements include items such as a new roof or an added garage. In this example, assume you paid $10,000 for a new roof. Add $10,000 to $215,000 to get $225,000.Step 3
Subtract from your result the amount of depreciation you were allowed to deduct while you owned the property to determine your adjusted basis. Depreciation is a tax deduction to account for wear and tear on the property and does not refer to a decrease in property value. Continuing with the example, assume you were allowed to deduct $100,000 in depreciation. Subtract $100,000 from $225,000 to get a $125,000 adjusted basis.Step 4
Subtract the closing costs of selling the property from the property’s sales price to determine your adjusted sales price. In this example, assume you paid $20,000 in closing costs and sold the property for $350,000. Subtract $20,000 from $350,000 to get a $330,000 adjusted sales price.Step 5
Subtract the adjusted basis from the adjusted sales price to determine your capital gain. Concluding the example, subtract $125,000 from $330,000 to get a $205,000 capital gain.
- The amount of income tax you pay on your capital gain depends on how much depreciation you were allowed to take on the rental property and how long you owned it.
- Downtown Apartment Building image by Carol Wingert from Fotolia.com