Calculating Taxes on a Rental Property Sale

For rental property owners, it's important to understand the tax implications when you decide to sell. The profit you make from the sale will be subject to capital gains tax, which has different rates and rules than the tax on your regular income. Additionally, there are other potential taxes like depreciation recapture and state taxes to consider. Properly calculating the full tax burden can help you plan appropriately.

Capital Gains Tax

When you sell a rental property for more than your cost basis (what you paid for it initially plus certain expenses), you will owe capital gains tax on the profit. The capital gains tax rate depends on how long you owned the property:

Short-Term Capital Gains

(Property owned 1 year or less) Short-term capital gains are taxed at the same rate as your ordinary income tax bracket, which could be as high as 37% currently.

Long-Term Capital Gains

(Property owned more than 1 year) Long-term capital gains receive preferential tax rates of 0%, 15% or 20% depending on your taxable income and filing status.

Calculating Cost Basis

To determine your capital gain, you need to calculate your adjusted cost basis in the property. This is the original purchase price plus certain fees and costs associated with acquiring and improving the property over your ownership period. Costs that increase your basis include:

• Purchase Price

• Legal Fees

• Closing Costs

• Cost of Renovations/Improvements

It's critical to keep detailed records and receipts of all expenses, as they can significantly increase your cost basis and reduce your overall capital gain.

Depreciation Recapture Tax

In addition to capital gains tax, you may also owe the IRS depreciation recapture tax if you claimed depreciation deductions on the property in prior years. Depreciation is an annual tax deduction that allows you to recover the costs of income-producing properties over their usable lifetime.

When you sell a rental with depreciation claimed, previously deducted amounts must be "recaptured" as income at a maximum 25% tax rate.

For example, if you claimed $100,000 in depreciation over your ownership period, up to $100,000 of your capital gain when you sell would be taxed at 25%.

State Taxes

Certain states also impose their own taxes on rental property sales in addition to the IRS capital gains tax. The rates vary, so check your state's tax rules.

Tax Minimization Strategies

There are some IRS-approved strategies you can use to defer or reduce taxes on a rental property sale, including:

1031 Exchange

This allows you to defer all capital gains tax by reinvesting the proceeds in a different income property of equal or greater value within 180 days. The 1031 exchange allows you to keep deferring the tax liability through multiple property sale/purchases.

Primary Residence Rule

For properties that were previously your primary home, you may be able to exclude up to $250,000 (single) or $500,000 (married filing jointly) of the capital gain from taxes.

Due to the complexity of rental property sale taxes, it's wise to consult a qualified tax professional to ensure you understand and comply with all the rules. Proper tax planning and record keeping can potentially save you thousands at sale time.