How to Avoid Paying Tax on a Rental Property Sale

Owning a rental property is a great way to earn passive income. As you build your real estate investment property portfolio, you can start living off your rental income. Real estate is also a large contributor to national revenue by way of property taxes levied by local and state governments.  Since there really is no way to avoid paying the tax, it can be beneficial to learn how to offset the taxed amount instead.

Taxes Assessed on Rental Property Sales

Selling a rental property is different from selling a primary residence; one of the primary differences lies in how the proceeds from the sale get taxed. When a primary residence is sold, it remains tax-free up to a certain monetary threshold. Beyond that threshold, taxes are assessed. This becomes a little more complicated when selling investment properties since you have to account for capital gain and depreciation taxes.

1. Capital Gain Tax

Capital gains tax factor in how long you’ve had the property in your investment portfolio. There are two types of capital gains, both of which are taxed differently. These are short-term and long-term capital gains.

Short-Term Capital Gains: This tax is levied when you’ve owned a rental property for less than a year. It works similarly to regular property taxes in which you pay the regular income tax for your income bracket.

Long-Term Capital Gains: This tax is levied when you’ve owned the property for over a year. Profits from long-term property holdings are given a more favorable tax rate.

2. Depreciation Recapture

Another tax that you will have to pay on the sale of rental property is depreciation recapture. You can write off depreciation as an expense for as long as you own the property. But when you sell, you will have to pay that money back.

For Example: If you owned a rental property for ten years and wrote off $4,000 each year for depreciation. You would owe $40,000 in depreciation recapture taxes after you sold the property.

Selling Rental Property and Avoiding a Tax Hit

1) IRS Code Section 1031

Section 1031 of the tax code allows investors to exchange real estate property owned for investment purposes with another property without incurring a tax. That means that if you sell one investment property to purchase a similar investment property there will be no gain or loss. So there would be no tax paid until the new property was sold.

• Rules

The tax code does not factor in capital gains taxes in all cases. For example, it does not work if you want to exchange a U.S. property with one in another country. Also, Section 1031 allows the avoidance of capital gains taxes on property that is for personal use.

Also, if you exchange the property and take advantage of Section 1031 but end up selling the property within two years, you will be subject to capital gains taxes. You will have to keep the property for at least two years if you plan to exchange the property according to Section 1031. You will still be responsible for paying any taxes on the property you want to sell those taxes will be shifted to the newly acquired property.

To take advantage of Code Section 1031, you will have to file Form 8824 with your federal tax return for the tax year during which the sale took place.

Conditions for a Tax-Deferred Section 1031

The following conditions must be met in order to take advantage of the benefits offered in Section 1031:

• The properties must be like-kind, meaning they may differ in grade or quality, but they have to be of the same nature or character.
• The property that’s purchased must be purchased for investment or business purposes.
• Within 45 days of acquiring the new property, the seller must be informed in writing of the new property to be received in exchange for an existing property.
• The exchange of like-kind properties must be completed within 180 days after the property transfer, or by the due date of the next year’s tax deadline, whichever comes first.

 

2) Make the Rental Property Your Primary Residence

Another way to avoid paying taxes is to turn your rental property into your primary residence. Selling a home you live in will save you more money in taxes than selling it as a rental property.

According to Section 121 of the tax code, you can exclude up to $250,000 of the profits from the sale of your primary residence for a single person and up to $500,000 if you are a married couple who file together.

To qualify for this tax deduction, you must own your home for a minimum of five years and must have lived in it for at least two years. However, it is not mandatory that those two years are consecutive. This is a prime reason why most investors convert rental properties into their primary residences.

How to Sell Rental Property

Selling a vacant home is relatively simple; you just have to stage it, list it in the MLS, and wait for potential buyers. The process becomes a little more complicated when there is a tenant living on the property.

If the tenant is in a month-to-month lease, just give your tenant a written notice and ask them to move out once the month ends. If they don’t move out, you may begin the eviction process.

Sometimes landlords add a termination clause to rental agreements. Which states that the lease can be broken under certain circumstances such as violation of lease terms. If there’s significant damage to the property, or if the landlord needs to sell the property. But things become complicated when tenants have long-term leases without such clauses in them.

Tenants have the right to live on the property if there is no termination clause as long as they are paying rent and following the lease rules. Your best bet is to wait until the end of the lease term before asking them to move. Or, if you have to pay and cannot afford to wait, you will have to enter into some settlement with the tenant where you pay them to move out. There is no defined amount, but generally, you should offer to afford their moving cost or cover their security deposit at a new rental.

Or, if your tenant loves your home and might be willing to buy it, it may be worth your while to offer them the option to rent to own.

FAQs

Is it possible to avoid paying taxes on the sale of a rental property?

Yes, there are several strategies that can help you avoid or reduce the amount of taxes you owe on the sale of a rental property.

Can I offset capital gains on a rental property sale with capital losses from other investments?

Yes, you can offset capital gains on a rental property sale with capital losses from other investments. By utilizing tax-loss harvesting, you can sell investments that have experienced losses to offset the capital gains from the rental property sale. This can help reduce your overall tax liability.

What is the concept of a stepped-up basis, and how does it affect taxes on a rental property sale?

Stepped-up basis refers to the readjustment of the property’s value for tax purposes upon inheritance. If you inherit a rental property, its value is “stepped up” to its fair market value at the time of the owner’s death. This can reduce your capital gains tax liability if you decide to sell the property after inheriting it.

Are there any tax implications if I choose to hold onto the rental property instead of selling it?

Holding onto a rental property instead of selling it may have tax implications. You will continue to be responsible for reporting rental income and potentially paying taxes on the rental income received.

Conclusion

Knowing your end game certainly gives you an edge over a typical investor. When you have a strategy in advance, you can execute a plan for paying any taxes that may be assessed as the result of your property sale.

You also never know if you will have to live in a house that was primarily purchased for use as a rental property. You can diversify your investment portfolio so that you can pair your losses with any gains you make from selling investment properties. Whatever you decide is in your best interest, at least now you know your options.