One problem with doing well with an investment is that the Internal Revenue Service is usually waiting with its hand out at the end of the transaction, expecting its share in taxes. If you sell your rental property, which is a "capital asset," and make a profit, the profit is called a "capital gain." Typically, you'll have to pay capital gains tax on this profit, but if you use a maneuver called the "Section 1031 exchange," for one example, you'll be able to avoid the tax.
A Section 1031 exchange occurs when you reinvest the proceeds of your rental property sale into the purchase of another investment property ... provided you do not keep any cash from the sale.
Capital Gains Tax
Capital gains taxes come due when you sell an asset for more than the money you have invested in it. The IRS wants 15 percent of your gain if you are married filing jointly, and have taxable income between $77,200 - $479,000. If you earn more than $479,000 as a jointly filing couple, you can expect to pay 20 percent tax on your long-term capital gains. You can, however, avoid taking a significant tax hit with some planning.
Section 1031 Exchange
If you're not looking to take cash out of your rental property, you can simply roll one investment into another in a 1031 exchange to avoid paying capital gains tax. The IRS allows you to sell one investment and reinvest the proceeds without taxation. The swap must be a "like-kind" exchange, but the IRS is relatively lenient about this with regard to real estate.
You don't have to exchange your three-bedroom rental property for another three-bedroom rental property. You can sell your rental home and buy undeveloped farmland or even a commercial strip mall if you like, as long as the asset on both ends of the exchange is real property and both are located in the United States. This rule only applies to investment properties. You can't do a 1031 exchange for the sale of a condo your college student lived in before graduating. If you never rented out the property, it's a second home, not an investment.
1031 Exchange Deadlines
Another rule involves the timing of a 1031 exchange. You don't have forever to pull off the swap – in fact, you have less than a year. First, you must find another piece of suitable real estate within 45 days after the sale of your first property. Then you must commit to the purchase in writing, not with the seller but with a disinterested third party who acts as an intermediary. In tax terms, disinterested means he cannot have any sort of business relationship with you, such if he has acted as your real estate agent, your accountant or your attorney.
The 45-day deadline runs concurrently with a six-month deadline. Within 180 days, you must close on the new property. If your tax return for the year in which you sold your rental property is due before this six months elapses, you don't have the entire 180 days to close. The deadline cuts off when your tax return is due, but it includes any extensions you take. Assuming you act in time and meet these deadlines, you won't owe capital gains tax on the sale of your property.
Tax Loss Harvesting
If you want to take cash out of the sale or you can't manage a 1031 exchange, take a good hard look at your investment portfolio. Tax law provides for an option familiarly known as "tax loss harvesting." If you own anything you can sell for a loss, and if you don't mind doing so, the loss can offset capital gains. For example, if you gain $100,000 from the sale of your rental property and you sell another investment at a $50,000 loss, you would only owe tax on $50,000.
Converting the Property
If you know in advance that you eventually want to sell your rental property, you can move into the home first and minimize any capital gains tax. The IRS offers a tax exclusion of $250,000 for single taxpayers and $500,000 for married taxpayers for capital gains resulting from the sale of their primary residence.
If you rented out your property when you bought it, but if you then live there for two years before you sell it, you can claim a portion of this exclusion if you owned the property for at least five years. Your exclusion is reduced by the amount of time the home served as an investment property. For example, if you owned the property for eight years, rented it out for six years, and lived in it for the last two years, it served as an investment property 75 percent of the time. Therefore, you can exclude 25 percent of your gain from taxation.
Beverly Bird has been writing professionally for over 30 years. She specializes in personal finance and w, bankruptcy, and she writes as the tax expert for The Balance.