Sell Your Rental Property for a Profit

Unlike shares of stock, investment properties can’t be unloaded in a few seconds with a click of your mouse. They aren’t liquid investments and the time between the decision to sell and the actual date of sale is often measured in weeks or months.

As many may know, selling a home can be an intimidating process if you don’t know where to start. But selling an investment property requires even more work.

But while the capital and taxation issues arising from investment real estate sales may be complex, you can accomplish such a sale on your own.

In this article, we’ll look at some of the reasons for selling an investment property and focus on how to limit taxes on the gains.

Key Takeaways

• There are various reasons for selling rental properties, including to book profits and to get rid of a money losing investment.
• The sale of an investment property can take a lot of work and sometimes much time.
• A 1031 exchange allows you to defer capital gains taxes on income from a property sale by investing that income in a similar property.
• Incorporating may lessen your taxes on income from rental properties.

Why Sell?

The reasons for selling a rental property vary.

• Real estate owners who personally manage their properties may move and wish to invest in real estate near their new residence.
• A landlord may want to cash in on the appreciation of a rental property rather than accumulate money through rent.
• An owner may have a property that is losing money, due to either vacancies or rental income that is insufficient to cover expenses.

Regardless of the reason, real estate investors looking to sell will have to deal with the taxes associated with the income from a sale.

Capital Gains Taxes on Property Sales

The capital gains tax on a rental property sale can be much steeper compared to the straightforward sale of personal-use property.

The basic capital gains taxes that you have to pay on the profit from the sale are increased by any depreciation deduction that you claimed.

This means that if the property lost money and you offset the loss against your tax bill in previous years, you will have a larger tax bill when the sale goes through.

Example: Capital Gains Tax and Depreciation

Let’s say you have a rental property that you bought for $150,000 and it sells for $200,000. Usually, this means that you pay a capital gains tax on $50,000 ($200,000 – $150,000).

However, if you deducted $20,000 in depreciation during the period of time that you owned the property, you will owe capital gains taxes on the, now greater, $70,000 difference between the sale price and your purchase price minus depreciation ($200,000 – ($150,000 – $20,000)).

Importantly, this shouldn’t discourage you from claiming depreciation losses. It is almost always better to realize tax breaks sooner rather than later (or not at all).

Important

If you’ve taken depreciation tax deductions, you may owe taxes when you you sell. The Internal Revenue Service (IRS) wants the tax payments that you would have made if you hadn’t gotten the tax breaks for the depreciation.

Defer Taxes by Reinvesting Gains in Like-Kind Property

Internal Revenue Code Section 1031 allows real estate investors to defer taxes on their gains by re-investing them in like-kind property.

With the help of a lawyer or a tax advisor, you can set up the sale so that the proceeds are put into an escrow account until you are ready to buy a new property. There is a time limit of 45 days to choose the new property and six months to complete the transaction.

If you intend to do a 1031 exchange, you should start looking for the new property before you sell the old one.

Alternatives to a 1031 Exchange

If you merely want to stop being directly involved with the property, you can either hire a professional property manager for your current place or sell it and buy a professionally-managed property. However, if your goal purely is to raise capital, you will just have to pay the capital gains tax bill.

1031 Exchange Professionals Can Help

If you decide to carry out a like-kind 1031 exchange, be aware that the process can be quite complex.

Therefore, it may be worthwhile to work with a reputable, full-service 1031 exchange company. Given their scale, these companies are generally less expensive than paying an attorney by the hour.

A firm that has a solid track record in dealing with these transactions can help you avoid costly missteps and ensure that your 1031 exchange is in accordance with tax regulations.

Incorporation Can Lessen Taxes

Incorporation is becoming increasingly popular for real estate investors. By incorporating, investors can reduce their liability. That’s because the corporation acts as a shield between you and potential lawsuits. Your house and personal finances are protected from any court action or legal proceeding.

Corporations also have different tax rules that are quite favorable, especially for capital gains that result from selling a property.

For a certain type of real estate investor, incorporation makes sense. If you employ people to find and manage a wide range of income-producing properties and make significant profits at it, incorporation will lessen your tax bill. You will see the profits through the share structure of your corporation.

But most real estate investors can get the benefits of incorporation without complicating how income is realized.

Difficulties Posed By Incorporating

• Incorporation can create a barrier between you and the earnings from your property. So if you depend on that income, you may not be able to access it as easily as you’d like, particularly the large profits made from selling a property.
• It is comparatively easy to incorporate, requiring only some professional advice and paperwork. But getting your properties out of a corporation (for example, to sell them off and retire) is more complex. You are walking the line of intentional tax evasion/fraud unless you sell the corporation instead of the properties.

Alternatives to Incorporation

If you personally manage two or three properties and have even one or two more that are professionally managed, you may not benefit from incorporation.

Should the income from your rentals not outpace your expenses for each property by a large margin, you’d be better off holding the properties as is, and use depreciation and write-downs where you can. Or you can change your real estate holdings into a small business.

In addition to using small business as an alternative to incorporation, some states allow real estate investors to open a separate limited liability company for each property they own.

While this doesn’t necessarily lessen the taxes, it does protect your finances, as well as each property, from litigation against any one of them.

What Is the Depreciation and Recapture Tax?

Depreciation expense is a great benefit of owning income-producing real estate. However, when you sell a rental property, the IRS wants to recapture that money. It does so by taxing the depreciation expense for each year at your ordinary income tax rate.

What Capital Gains Tax Rate Is Paid on a Rental Property Sale?

That depends. A short-term capital gains tax rate, which is the same as the investor’s ordinary tax rate, is charged when a property is sold after an ownership period of one year or less. A long-term capital gains rate of either 0%, 15%, or 20% is charged when a property is sold after an ownership period of more than one year. Which long-term rate the investor pays depends on their annual income and filing status.

What Is the Qualified Intermediary in a 1031 Exchange?

A property owner isn’t allowed to receive the proceeds from the sale of rental property in a 1031 exchange transaction. The qualified intermediary in a 1031 exchange is a person (unrelated to the property owner) or entity that handles those proceeds and facilitates the subsequent purchase of a like-kind property.

The Bottom Line

Selling a rental property can be challenging if you are hoping to avoid a large tax bill on the proceeds.

If you are selling to invest in a different property, then you can simply do a 1031 exchange and defer the capital gains tax bill. If you are selling because you need the capital, you will have to pay some taxes.

If you have rental property that is breaking even or making a profit, consider holding on to it instead of selling to keep the tax collector at bay.