If you own rental property, it is absolutely essential to understand that your capital gains on this property will be calculated much differently than on real estate that acts as your personal residence. Without a thorough knowledge of this process, you may find yourself accountable for a surprisingly large tax burden. That being said, keeping a close eye on your expenditures and investments related to your rental property will help you calculate an accurate basis on which your capital gains can be properly reported.
In order to calculate capital gains from the sale of a rental property, you will need to document any and all home improvements, deductions and depreciation that could influence the adjusted cost basis of the property.
Accounting for Home Improvements
When you begin the process of assessing your capital gains, you first have to calculate the purchase price – or basis – of your rental property. However, any and all expenditures you have made in an effort to improve the quality of the property can be used to augment the basis of the property.
This is incredibly important to document, as it will help reduce the amount of capital gains you will have to pay in the event that your property has gained value during your ownership. If, for example, you have undertaken a kitchen remodeling or similar home improvement, all costs related to the improvements can be factored directly into your basis.
Assessing Deductions and Depreciation
With this newly configured basis, you must then account for any depreciation that may have occurred. Consult your prior tax returns to determine what accumulated depreciation must be accounted for when calculating your new basis. Likewise, you must subtract any tax credits you have received during ownership of the property from your adjusted basis. For example, if you have taken advantage of energy saver credits or other exclusions, these must be taken out of the adjusted basis, which you will use to calculate your capital gains.
Evaluating Sale Price
Once you have sold your rental property, you must subtract the adjusted basis from the selling price to determine what gains will be taxed under the capital gains tax rate. When you sell your property, you will report all financial details related to the sale in Schedule D of the 1040 tax return form. If you have claimed any depreciation on the property during your tenure of ownership, you will also have to report this on Form 4797.
As you can see, a lower adjusted basis will often result in higher capital gains in the event that your property gains value during ownership. With this in mind, you can use the information provided here to create your own ideal strategy for balancing home improvements and property investments relative to your likely year-end tax burden.
Ryan Cockerham is a nationally recognized author specializing in all things business and finance. His work has served the business, nonprofit and political community. Ryan's work has been featured on PocketSense, Zacks Investment Research, SFGate Home Guides, Bloomberg, HuffPost and more.