While rental property often generates ongoing tax-advantaged profits, you could face a substantial tax liability if you sell a piece of real estate for more than its depreciated value. The IRS assesses taxes against your capital gains, and the Patient Protection and Affordable Care Act (Obamacare) could impose additional tax liability on a particularly profitable property.
When you’ve owned a piece of rental property for over a year, any profit on the sale is taxed as a long-term capital gain, at a rate of 15%. To calculate your tax liability, subtract your basis (purchase price plus any closing fees and capital improvements) from your net selling price (selling price minus commissions and closing charges).
If you live in a state with an income tax, you could also owe state income tax on your capital gain and depreciation recapture. California, for instance, taxes both capital gains and recapture as regular income. A married couple’s taxable income over $103,060 is taxed at a 9.3% rate, with incomes in excess of $1,000,000 subject to an additional 1% tax, for a total rate of 10.3%.
Net Investment Income Tax
The Net Investment Income Tax may be applicable to the sale of your property. This is a 3.8% tax that is used to help fund the Affordable Care Act (Obamacare). If your modified adjusted gross income exceeds $200,000 if you’re single, or $250,000 if you’re married and filing jointly, you will owe this tax. The Net Investment Income Tax is calculated on Form 8960, and will be reported and paid with your Form 1040.
Avoiding Depreciation Recapture
When you sell your property, you’re required to return the depreciation deductions you’ve been entitled to over the years. The IRS requires that you repay depreciation on sold property in the form of Section 1250 depreciation recapture taxes. Your tax liability will equal 25% of the total depreciation you’ve claimed over the course of your ownership. Even if you failed to claim depreciation, you will still be required to pay recapture tax – just as though you had taken the depreciation deduction all along. This means that depreciating your property doesn’t harm you when you sell, but it really helps you while you still own it. The good news is, you can avoid paying the recapture tax. By reinvesting the sale proceeds into more investment real estate, you can structure the transaction as a 1031 exchange.
A 1031 exchange is a “like-kind” swap that permits you to reinvest the proceeds from your property sale, tax-free. The IRS is generally pretty lenient about what constitutes a “like-kind” exchange, so you can swap just about any real property located in the United States for any other real property – such as trading commercial for residential. You’ll be required to follow a strict set of IRS guidelines, starting with the fact that you have less than one year to complete the swap. You must locate another piece of suitable real estate within 45 days of the sale of your first property, commit to the purchase in writing, and close on the new property within 180 days.
The information herein is general in nature and should not be considered insurance, legal or tax advice. Please consult with an insurance legal or tax professional for additional information on specific situations.
Investment advisory services provided by Werba Rubin Wealth Management, LLC (“Werba Rubin”). Securities transactions are offered through a non-affiliated entity, Loring Ward Securities Inc., member FINRA/SIPC.