Property can be a lucrative investment. It almost always eventually appreciates in value, ensuring you’ll make a profit when you finally do sell. You can boost that profitability by renting out your investment property, either as a short-term rental to vacationers or a long-term rental to tenants who live in the property for months or years. But when it’s time to sell your rental house, you may take a hit on some of the money you earned, especially if you sell it for more than you paid. But there are ways to reduce some of the taxes you’ll owe.
Taxability of Rental Home Sales
Income tax is designed to collect a portion of any income you bring in during the year. Therefore, if you sell a home for the same price or less than you originally paid for it, you don’t owe taxes because there was no income. Where taxability becomes a question is when you earn money from your property sale. This is known as capital gains, and it is taxed at a separate rate from your other income. With capital gains tax, the IRS collects money on the income you earn from the sale of an asset, such as a home, share in stocks or a business. But the amount of tax you pay depends on how long you held the asset before you sold it.
Where confusion comes in with rental property is that if you sell your primary residence at a profit, you generally don’t have to pay capital gains taxes. That’s because the IRS exempts taxpayers on those sales, as long as they fit the criteria. You must have lived in the home for at least two years, it has to be your primary residence and you can’t have sold another primary residence without claiming the exemption in the past two years. Since that exemption only applies to your primary residence, you won’t be able to take it on a secondary residence, whether you’re using it as a rental property or vacation home.
Capital Gains on Rental Properties
When you sell your rental property at a profit, the capital gains tax you’ll pay depends on how long you owned the home. Each year, the federal government sets separate capital gains tax rates for short-term and long-term asset ownership. If you’ve owned the home for one year or less, you’ll be taxed based on the current short-term capital gains rate. For 2018, short-term capital gains tax is based on whatever your ordinary income tax rate is. The tax brackets have changed under the new tax laws, so you’ll need to check your current rate, but if you're a single filer and your annual taxable income is between $38,701 and $82,500, you’ll pay $4,453.50 plus 22 percent of the amount over $38,700 on your entire income for the year, including any gains you made when you sold your rental home.
Chances are, though, that you’ve held your rental property for more than a year before deciding to put it up for sale. If that’s the case, the much lower long-term capital gains tax rates will apply. Those rates are also based on your income and are 0 percent, 15 percent or 20 percent. If your total income for the year is less than $38,601, you won’t pay any tax at all on your capital gains. If you earned between $38,601 and $425,800, you’ll pay 15 percent tax on the gains from your rental property sale. For those who earned more than $425,801 during the tax year, capital gains will be taxed at 20 percent.
Reducing Your Tax Burden
Fortunately, there are ways you can offset some of that tax burden. If you find you’ve made a significant profit on your rental property sale, the best thing you can do is to reinvest that money. Many property investors use something called a 1031 Exchange to avoid losing money in taxes. With a 1031 Exchange, you simply take the money you made on the sale of one property and use it to buy another. So if you’ve sold your beach condo in Malibu, you’d take the earnings and buy another beach condo, perhaps in an area that will bring in more vacation rental income each year.
To make a 1031 Exchange work for you at tax time, you’ll need to sell your property, then put the proceeds into a “like-kind” property, which means the new home needs to be similar in type to the one you just sold. So if you sold a rental property, you’ll need to be able to show that the new property you bought brings similar benefits to your business. You have 45 days to reinvest the money into the similar property and only 180 days to close on that property.
Reduction in Basis
There’s another complication that you need to factor into your tax obligations. During the time you owned your rental property, you probably claimed depreciation on it as directed under tax law. Even if you didn’t, you’re required to subtract that depreciation when you sell the rental home. If you hold on to a property for 27.5 years, that reduction reverts all the way to zero, which means you have no depreciation left, but in the years leading up to that, your property will be subject to a deduction based on that assumed loss in value.
Unfortunately, when you decide to sell your property, it’s time to report all those deductions on your taxes, also known as “recapturing your depreciation deductions.” The recapturing process means you report those deductions on Schedule D and pay taxes on them. This is because it is assumed that these depreciations increased the amount you’ll gain when you sell the property. The tax rate for depreciation deductions is 25 percent. However, if you’ve done any improvements on the property or put money into restoring it after a disaster, you can claim an increase in basis, which will help to offset those deductions.
Converting to Primary Residence
If you’re looking at selling a rental property, one option may be to simply move into it. If you don’t have a primary residence, or you're considering selling the one you do have, this can be especially appealing. However, to enjoy the tax benefits that come from making a profit on the sale of your primary residence, you’ll need to live there for at least two years. Also notable is the date you sold your previous primary residence without paying taxes on any profit you made from the sale. You’ll need to wait at least two years from the date of that transaction to put the rental property you just moved into up for sale.
But a rule passed in 2008 could affect your ability to simply move into your rental home and make it your primary residence without tax repercussions. This rule limits your ability to claim the exclusion on a home that was initially a rental but became a primary home. Under the rule, you’ll be required to reduce the amount of profit you gained after 2008 for every year you used it as a vacation or long-term rental property. It’s important to determine exactly how this will affect you before getting a rental van and moving your belongings into your rental home.
- Bankrate: How to avoid paying capital gains tax when selling your home
- NerdWallet: 2018 Capital Gains Tax Rates — and How to Avoid a Big Bill
- Clever: How To Avoid Taxes When You Sell A Rental Property
- Investopedia: How to Prevent a Tax Hit When Selling a Rental Property
- Nolo: Taxes You Need to Pay When Selling Rental Real Estate
- Nolo: Taxes When You Convert Your Rental Property to Your Personal Residence