Selling Rental Properties: Overview of Taxes and Expenses
Real estate investing is a great way to build a portfolio of appreciating assets while also generating rental income. But, as investors get older they may look to sell some rentals. Selling rental properties incurs taxes and expenses and some sellers end up with less money than they expected after the sale. Chase and Jen provide an example below.
Example Rental Property Sale
Chase and Jen are married and purchased a rental property five years ago for $200,000. They have an offer to sell the property for $400,000. Initially they expect to earn a profit of $200,000. However, after some research they realize they will pay the following expenses:
$24,000 for a 6% sales commission paid to the listing agent;
Approximately $7,250 in recapture tax, which is 25% of the $29,000 in depreciation taken over the past five years of owning the property;
Approximately $26,000 in capital gains tax; and
$2,500 in closing costs as part of the sale.
The $59,750 in total expenses reduces their profit to $140,250. They are also required to pay State income tax on their gains which further reduces their final profits. Note: A more detailed explanation of real estate depreciation can be found here.
Options for Reducing or Deferring Taxes
There are a few ways to avoid, or defer, some of these taxes and expenses. There are also alternatives to selling that will not trigger a taxable event, such as cash out refinancing. They may also want to provide seller financing to the buyer, which will spread the taxes owed over a series of years. Below are five strategies to consider when selling a rental property.
1. 0% Capital Gains Tax: In 2022 a single tax filer can pay a 0% capital gains tax rate if they earn less than $41,675. A married couple filing a joint return can pay a 0% capital gains tax rate if they earn less than $83,350. If a rental property seller has a total capital gain below these amounts they can eliminate their capital gains tax. This assumes that in the year the property is sold, the seller has no other income. If the seller does have other income they may only get the 0% rate on part of their gains.
Hence, it can be advantageous for an investor to sell a rental property in a year that they will not have much income. For example, timing the sale of the property during the first year of retirement or when taking a year off from work to travel, can eliminate part or all of the capital gains tax. A seller is still responsible for any recapture tax on depreciation, but tax obligation for capital gains could be zero.
2. 1031 Exchange: A 1031 exchange allows an investor to sell a rental property but delay paying taxes as long as the sales proceeds are reinvested in another property. The proceeds from a 1031 sale must be used to acquire a “like kind” property within a specified period. The term “like kind” means the next property must be of a similar nature but not necessarily the same grade or quality.
If an investor sells a single family property they could use the proceeds to buy a multi-family property or a commercial building, but not artwork or a classic car, as these are not "like kind" investments. The 1031 sale and acquisition must follow a precise order or the sale will be deemed a taxable event by the IRS and all the taxes will come due. The process for a 1031 exchange is covered in more detail here.
3. Cash Out Refinancing: One of the best strategies for minimizing taxes and expenses is to refinance instead of selling. Refinancing allows the owner to pull out a portion of the equity as cash. Refinancing a property is not a sale and therefore does not trigger the taxes explained above.
For example, Chet has a rental property worth $400,000 with a loan balance of $50,000. He refinances the property with a new mortgage of $250,000. He pays off the $50,000 loan and now has $200,000 in cash to invest elsewhere. Refinancing may cost him $5,000 in closing costs, but this is far less expensive than a sale. A detailed article on using cash out refinancing to create a net worth of $1 million is here. Cash out refinancing is particularly effective for investors who expect interest rates to rise in the near future. Refinancing allows investors to raise funds at today's lower interest rates and avoid higher rates in the future.
4. Primary Residence Conversion: This option involves moving into a rental property to convert it into a primary residence. The gains on a rental property are subject to capital gains taxes, but if the property is used as a primary residence the taxes can be reduced for these years. For example, renting a property for five years and then living in the property as a primary residence for five years will cut the gains subject to capital gains tax in half.
This is because for the five years the property was used as a primary residence, the seller is able to take advantage of the primary residence home exemption. This exemption allows the seller of a primary residence to exempt the first $250,000 from capital gains taxes, if they are single, and $500,000 if they are married filing jointly. This strategy can also be combined with the 0% capital gains tax strategy explained above to shield some of the other gains that would be subject to capital gains taxes. Understanding taxes is one of the best ways to accelerate your journey towards financial freedom.
5. Seller Financing: As mentioned above selling a rental property incurs capital gains taxes due in the year the property was sold. However, if the seller offers to finance the buyer for the sale the capital gains taxes will be spread out over multiple years. This approach reduces the immediate tax hit and creates an income stream for the seller in the form of monthly payments.
For example, Jenna bought a rental property several years ago for $150,000. She sells it to Vance for $300,000 with seller financing. Vance pays Jenna $30,000 as a down payment and he pays her the remaining $270,000 over the next 10 years. Vance will also pay Jenna an interest rate of 6% per year on the amount financed.
Essentially, Jenna has spread out 90% of the sale of her rental property over the next ten years. She only owes capital gains taxes on the portion of the property sold in each individual tax year. She will also pay income tax on the 6% interest earned from Vance each year.
Sellers who choose to finance the sale, must perform their due diligence. This includes assessing the credit worthiness of the buyer and having a knowledgeable real estate lawyer draw up the contracts. And when it comes to tax planning for any investment, be sure to consult a tax professional.
Rental properties are a valuable tool for achieving financial freedom, particularly when investors understand the tax advantages. If you are interested in learning more about real estate investing consider the book Become Loaded for Life and see the articles in the Real Estate section.
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