Knowing when is or isn't the right time to sell a rental property can be a challenge and is a decision that definitely shouldn't be taken lightly. While selling may free up extra cash, it can also come with some pretty substantial losses as a result of the tax bills. It's undeniably a challenge to sell your rental property without taking a major hit to your finances; however, it's not impossible.
We've put together this short guide so that you can be better educated on the potential pitfalls that are associated with selling rental properties and a few steps that you can take to avoid them. Remember, everybody's circumstances are different and to get the most accurate idea of what's best for your individual situation, you should enlist the services of a professional accountant.
Capital Gains Taxes
Selling your rental property can earn your massive profits but will incur capital gains taxes. These taxes are applied when an asset is sold for a profit and are unavoidable. Capital gains taxes can be considered to be either short- or long-term. If you've owned your rental property for over a year, they're classed as long-term. Anything less than one year and it's classed as short-term. The IRS definition of a short-term gain is a property that you've owned for less than 12 months and is taxed at the same rate as your regular income tax.
It's a little more complex for long-term gains and the taxation can be anywhere between 0 and 20 percent - depending on which tax bracket you're included in. Selling a rental property can result in significant tax bills that are much greater than when you sell a property which has been used by you personally. If you have to declare any depreciation on the property, this will also increase the amount which is owed in capital gains tax.
When a property has been depreciated, the IRS still collects taxes on the sale of this property in a process known as depreciation recapture. It's a requirement of the IRS that rental properties being depreciated are done so over 27.5 years based on what is referred to as the useful life of a rental property. The "useful life" of a rental property is an estimate of the length of time that it can be effectively used as cost-effective source or revenue for the owner.
Working out the amount of depreciation that can be applied to your property's value is quite simple. By multiplying the price of the property by 3.636 percent for every full calendar year that it was in use as a rental property, you have the exact amount that can be depreciated. Depreciation is a solid way of decreasing the amount of taxes that are owed from the years of ownership. However, since the rental property is now being sold, the tax deduction is required to be repaid. This repayment is the depreciation recapture tax.
If the total value of a property was estimated at $600,000, as a result of the land being valued $200,000 and the housing unit being valued at $400,000, the depreciation expense would be calculated by multiplying the value of the housing unit by 3.636 percent or by dividing it by 27.5. It's important to remember that the IRS doesn't consider land to a depreciable asset and as such its value doesn't impact the depreciation recapture.
A 1031 exchange can be a good way of navigating past capital gains tax without losing too much of your investment. This allows the seller of a rental property to take the funds from the property sale and invest it into a different property while deferring any tax payments that are associated with the funds from the sale.
1031 exchanges have quite a strict set of requirements that must be adhered to. The IRS requires both properties to be similar enough to the other. It's important to find the property you wish to purchase before you begin the selling process of your current property. For owners looking to invest without gaining access to the immediate capital that's usually associated with a house sale.
A 1031 exchange is a fantastic way to avoid paying capital gains taxes. By selling one property and buying another, capital gains tax can be deferred, and more capital can be freed up and invested in the new replacement property. 1031 exchanges can require a high minimum investment and a long holding time. As such, these transactions are best suited to individuals with a high net worth who are not in need of immediate capital. Please remember, 1031 transactions are rather complex and should be handled by professionals.
For property owners looking to sell their current rental property and invest in another straight away, arranging a 1031 exchange is the best, most straightforward to achieve this all while avoiding any expensive tax bills. If you need to withdraw capital immediately, it's almost certain that you'll have to pay some form of tax. As such, if your property is earning your money or even if you're breaking even, you should consider avoiding selling - even for a 1031 exchange.
Selling your rental property without incurring huge bills can be tricky, but hopefully this short guide has helped to clear things up for you. Doing your research is essential, as is ensuring that you're prepared for all eventualities. Avoiding any potential pitfalls associated with selling your rental property can ensure that the financial impact on you and your family is kept to a minimum as well as ensuring that you get to keep as much of the eventual profit as possible.