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When you sell an investment property, all of your profits are subject to either capital gains tax or depreciation recapture tax, which is a special type of capital gains tax. Your tax gets calculated on the difference between your cost basis and your selling price. Any debt that you owe, such as the balance on your mortgage, will not affect your capital gains liability.
Your Cost Basis
Your cost basis isn’t just the purchase price of your investment property. The initial cost is what you actually paid at the closing, including your closing costs.
For example, if you bought a small apartment building for $1 million and paid $1,500 in title fees, $5,000 in attorney’s fees, $2,000 in miscellaneous fees, and $8,000 in inspection fees, your actual cost would be $1.0165 million.
To that cost, add the cost of any improvements you made to the property. Improvements are anything that changes your property’s use, increases its value, or extends its useful life. Taking the apartment building as an example, a $50,000 roof and $115,000 in kitchen and bathroom renovations would count as improvements and increase your cost basis to $1.1815 million.
Depreciation and Basis
While you own your investment property, the tax code lets you claim a small portion of its cost basis every year as a depreciation write-off. Depreciation is an accounting tool that simulates the decline in value that accompanies the gradual deterioration of buildings (although in recent years, almost all property has actually gained value over time).
When you sell it for more than the depreciated value, the IRS will want you to return a portion of the money that you saved by claiming depreciation. To properly calculate your capital gains liability, you will need to total all of the depreciation that you were legally entitled to claim, whether or not you actually claimed it.
Calculating Tax Liability
You owe capital gains taxes on the difference between your adjusted cost basis and your net selling price. If you, for example, sell your apartment building for $1.95 million and pay $105,000 in commission and $8,700 in closing costs, your net selling price is $1.8363 million. Subtracting your $1.1815 million cost basis gives you a taxable capital gain of $654,800.
In addition, if you sell for a profit, you will have to pay depreciation recapture taxes on all of your accumulated depreciation. If you claimed $320,000 in depreciation while you owned your building, you need to pay depreciation recapture tax on all of the $320,000.
If you sell for a loss, you will pay recapture tax on the difference between your net selling price and your depreciated basis. For example, if you sold the building for $925,000, you would have a capital loss, but since your depreciated basis would be $861,500 ($1.1815 million minus $320,000), you would pay recapture tax on the $63,500 difference.
Federal Tax Rates
Capital gains on assets that you hold for at least one year are considered long-term gains. For the tax year 2019:
- Taxpayers filing single pay 0 percent capital gains tax (income up to $39,375), 15 percent capital gains tax (income $39,376 to $434,550) and 20 percent capital gains tax (income more than $434,550).
- Taxpayers filing married filing jointly pay 0 percent capital gains tax (income up to $78,750), 15 percent capital gains tax (income $78,751 to $488,850) and 20 percent capital gains tax (income more than $488,850).
- Taxpayers filing head of household pay 0 percent capital gains tax (income up to $52,750), 15 percent capital gains tax (income $52,751 to $461,700) and 20 percent capital gains tax (income more than $461,700).
- Taxpayers filing married filing separately pay 0 percent capital gains tax (income up to $39,375), 15 percent capital gains tax (income $39,376 to $244,425) and 20 percent capital gains tax (income more than $244,425).
Short-term gains are taxed at your marginal income tax rate. In addition, depreciation recapture is taxed at 25 percent.
You may also be subject to a 3.8 percent Medicare surtax if your income exceeds $200,000 if you are single or $250,000 if you are married. These rates went into effect for the 2013 tax year and will not change without new laws being passed. It’s always a good idea to verify these rates with the IRS or your accountant.
Loans and Gains
What you pay off on your loan isn’t tax-deductible. However, you can amortize many of the costs of getting your loan over its life.
For example, if you pay $12,000 to take out a mortgage with a 10-year term, you can write off $1,200 per year. If you were to sell your property after only three years, you’d have $8,400 in remaining loan fees that you hadn’t claimed. You would be able to add those remaining fees to your cost basis, reducing your gain when you sold your property.
How to reduce or avoid capital gains taxes
Capital gains taxes can take a significant bite out of your profits. But there are ways to reduce or even avoid these taxes on the proceeds from the sale. Here are three strategies.
1. Turn your investment property into your primary residence
The easiest way to limit or avoid the capital gains tax is to convert your investment property to your primary residence. The reason? If you sell a primary residence, you don’t have to pay taxes on the entire gain. That’s because IRS Section 121 lets you exclude up to:
- $250,000 of capital gains on real estate if you’re a single filer.
- $500,000 of capital gains on real estate if you’re married and filing jointly.
To count as your primary residence, you must own and live in the house for at least two of the five years immediately preceding the sale. Say, for example, that you bought an investment property in 2010, and in 2015 you converted it to your primary residence. In other words, you moved in and called it home. In 2019, you can then sell the property as a primary residence because you lived in it (and owned it) for at least two out of the previous five years.
2. Offset gains with losses
Another way to lower your tax liability when you sell investment property is to pair the gain from the sale with losses from your other investments. This strategy is called tax-loss harvesting.
The IRS aggregates your gains and losses for the year. So even if you sell your investment property at a profit, you can offset those gains by losses you had in, say, the stock market. For example, if you had $53,000 in capital gains from selling your investment property, and in the same tax year had $50,000 in losses from bad stock investment, your capital gains would be limited to just $3,000.
One caveat to know: The tax code requires that short-term and long-term losses get used first to offset gains of the same type. But if your short-term losses exceed your short-term gains, you can apply the excess short-term losses to any long-term gains. Likewise, if your long-term losses are greater than your long-term gains, you can apply the excess long-term losses to any short-term gains.
3. Take advantage of a Section 1031 exchange
If you want to sell an investment property — but don’t need to cash out just yet — you can defer paying capital gains taxes by doing a like-kind exchange.
Section 1031 is a provision of the U.S. tax code that lets you sell an investment property (called the “relinquished property”), buy a “like-kind” property, and defer paying taxes. This process is called a 1031 Exchange, a Starker Exchange, or a like-kind exchange. In most cases, a Qualified Intermediary (QI) acts as a third-party facilitator to ensure the process goes smoothly.
To qualify as like-kind property, it must be real property (i.e., real estate) that you’ve held for productive use in a trade for business or for an investment. Personal residences don’t count. Neither do vacation homes.
There are strict time limits for 1031 exchanges. After you sell your investment property, you have 45 days to identify up to three like-kind exchange properties.
After that, you must close on the new property within 180 days of selling your investment property, or before your tax return is due for the year you sold the property — whichever comes first. If you don’t meet these deadlines, the transaction won’t count as a 1031 exchange and any capital gains taxes will become due.
Capital gains taxes can take a big bite out of your profits when it comes time to sell your investment property. Fortunately, there are ways to lower and defer these taxes. Taxes are complicated and rules change, so it’s always recommended that you work with a qualified tax specialist to make sure you receive the most favorable tax treatment possible.
Sources: https://finance.zacks.com/calculate-capital-gains-sale-investment-property-mortgage-owed-9381.html | https://www.fool.com/millionacres/taxes/capital-gains/how-capital-gains-tax-investment-property-work/