Updated: Oct 6, 2021
We’ve received numerous calls over the past six months from clients asking about the tax implications of their home sale. With residential real estate appreciating nearly 15% from a year ago and the strong demand for homes today, we are going to take a few minutes this week to help you understand the tax implications of selling a home.
For any financial decision, the tax implications of a transaction should be considered in the decision-making process. Homes and rental properties are no different. Depending on the type of property sold, the income tax associated with a sale could be larger than you realize.
The simplest type of home sale is the sale of your personal residence. This is a home that you have owned and lived in 2 out of your last 5 years. Assuming you meet this threshold, the first $250,000 of the gains on a home sale would be excluded per person, meaning that a couple could exclude a gain of $500,000 on their primary residence before having to worry about taxes.
If you sell your personal residence, but have not lived there for a minimum of two years, then you will pay capital gains tax on a portion of the income, and the tax will be determined by how many months you've lived in the home.
Rental Property: Obvious and Not So Obvious Gains
The tax burden on rental properties is one that may be surprising to people, because there are two separate calculations on the taxable income.
The first type of tax is capital gains on sale of property. Rental properties, like stocks, bonds, and other assets, are considered investment property. This means that you are holding these assets for the generation of income, or appreciation in value. When you sell the property, you will pay tax on any gain realized from the sale of the home. For example, if you have rental property that you purchase for $275,000, and then sell it 2 years later for $300,000, you will have $25,000 in long-term capital gains (assuming no other investment went into the house). If you hold a property for less than 1 year, your gains will be taxed at your ordinary income tax rate. If you hold the property for longer than one year, then it receives the beneficial long-term capital gains tax treatment. This could mean a tax rate of 0%, 15%, or 20% depending on how much other income you have (see table below).
Long-Term Capital Gains Rate (2021)
The second type of tax, called depreciation recapture, is the one that most people are not prepared for when they file their taxes. Before we get into depreciation recapture, here is a quick summary of what depreciation is: Every year that you rent out your property, you can take what is called a depreciation deduction.
This means you can deduct the value of the home over a specified timeline, called its “useful life” (often this period is 27.5 years). This means that a rental property valued at $275,000 can take $10,000 of depreciation expenses every year in addition to any expenses incurred ($275,000/27.5) At first, this seems like a good deal. With the depreciation expense, you can have a loss on your rental property even when it produces a positive cashflow.
Unfortunately, the downside to depreciation comes when you sell the home.
Going back to our previous example, lets assume that you rent the property for 10 years and take a total $100,000 in depreciation expenses over that 10-year window. When you go to sell the property, you will be forced to “recapture” all previous depreciation taken and report it as income in the current tax year. This means that even if you sell your house for $275,000 and have no actual gain on the property (since you bought it for $275,000), you will still have $100,000 of income that you will be taxed on when you sell the property. This type of income is taxed at your ordinary income tax bracket, with a maximum tax rate of 25%. In the above example, that would result in you owing $25,000 in tax on the sale of your rental.
From a timing standpoint, this tax can be minimized by choosing to sell your property right after you retire, but before you go on social security. By choosing to sell the property during a period when your income has dropped, you may be able to minimize the impact the depreciation recapture.
Can I Just Avoid Depreciation?
A logical conclusion to the above would be to simply avoid reporting any depreciation, so that you wouldn’t need to recapture any depreciation. Unfortunately, the tax code requires that you realize the greater of the depreciation you captured or the amount you should have captured. This means that in the above example, you would be required to report the $100,000 of income, even if you chose no to take the $100,000 in depreciation over the last 10 years.
What Options Do I have?
When it comes to selling your rental property, your options become limited as to what you can do.
1. The first option is that you can simply pay the tax and net your cash. Although this may not be the most tax-efficient option, it does allow you to be done with a rental property and not have to worry about a future tax bill.
2. Your second option would be to execute a like-kind, or “1031,” exchange. This will require some additional steps and may not be a real option if you are looking to get out of the rental property business. In a 1031 exchange, you can defer all gains and recapture by locating a replacement property. A 1031 exchange requires specific rules and intermediaries, so if this is something you are considering, you should reach out to your realtor or real estate attorney well in advance of closing.
3. The final option would be to eventually move into the house and make it your primary residence. In this scenario, making it your primary home would mean that you can keep the house without having to worry about future depreciation. Unfortunately, if you sell the property at any point, you will need to recapture that depreciation even if it is a primary residence.
Throwing Gasoline on a Fire?
Beyond the 1-2 punch of capital gains tax and depreciation recapture, taxpayers should also be wary of a third tax their home sale may be subject to. The Net Investment Income Tax (NIIT) is an additional 3.8% tax on investment income for single individuals with income over $200,000 and MFJ filers with income over $250,000. This Obamacare era tax is subject to both capital gains tax and depreciation recapture, meaning that in our previous example where you realize $100,000 of depreciation recapture, you could have another $3,800 of tax due to NIIT.
How to Avoid Depreciation Recapture?
Fortunately, there is one way to avoid depreciation recapture. By holding on to the rental property and gifting it to your heirs after you pass, you can completely avoid the depreciation recapture. If an asset is transferred at death, the current rules state that property basis is “stepped up” to its current value and the asset is passed onto your heirs with no tax due.
What Does this Mean for Me?
As with most tax law, some transactions can be complex and some transactions can be simple. You should always speak to your accountant or financial planner before the sale of any substantial asset to have a better understanding of how your personal situation will be affected.
This article is a general communication being provided for informational and educational purposes only and is not meant to be taken as tax advice, investment advice or a recommendation for any specific investment product or strategy. The information contained herein does not take your financial situation, investment objective or risk tolerance into consideration. Readers, including professionals, should under no circumstances rely upon this information as a substitute for their own research or for obtaining specific legal, accounting or tax advice from their own counsel. Any examples are hypothetical and for illustration purposes only. All investments involve risk and can lose value, the market value and income from investments may fluctuate in amounts greater than the market. All information discussed herein is current only as of the date of publication and is subject to change at any time without notice. Forecasts may not be realized due to a multitude of factors, including but not limited to, changes in economic conditions, corporate profitability, geopolitical conditions, inflation or US tax policy. This material has been obtained from sources believed to be reliable, but its accuracy, completeness and interpretation cannot be guaranteed.
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