When you sell an investment property, you could potentially get a hefty tax bill -- even if you didn't make a big profit. In addition to capital gains taxes on a profitable sale, you may also have to pay back any depreciation benefits you received while you owned the property. In a nutshell, you could have a much larger tax bill in store than you're used to in the year you sell an investment property. However, there's a way that you could defer paying these taxes for as long as you want, as long as you keep investing your money in real estate. Here's a rundown of the taxes you might have to pay when you sell an investment property, when they're due, and how you could avoid paying them -- at least for a while.
The taxes you might have to pay when selling an investment property
There are two possible reasons you might owe taxes when selling an investment property -- capital gains and depreciation recapture.
Capital gains tax
The first is capital gains tax, which comes into play when you sell an asset for a profit. In other words, if you purchased an investment property with a cost basis of $100,000 including fees and closing costs and sold it for net proceeds of $120,000, you'd have a $20,000 capital gain. The tax treatment of capital gains depends on how long you owned the investment property. As long as your ownership period was greater than one year, you will have a long-term capital gain, which is taxed at preferential rates of 0%, 15%, or 20%, depending on your other income. If you sold an investment property that you held for a year or less, you'd have a short-term capital gain, which is taxable as ordinary income. Of course, if you sold your investment property at a net loss, you won't have to worry about capital gains tax. In fact, you may even be able to use at least some of the capital loss to offset your other taxable income.
The second type of tax you may face when selling an investment property is known as depreciation recapture. As an investment property owner, you are entitled to claim a depreciation deduction each year to help reduce your taxable rental income. For residential investment properties, this deduction is equal to your cost basis in the property divided by 27.5 for each full year of ownership. For example, if you spend $150,000 on an investment property, you get a $5,454 annual depreciation deduction, which can be a tremendous tax benefit when it comes to your rental income. The caveat is that when you sell the property, the IRS takes this benefit back through a tax known as depreciation recapture. You can calculate depreciation recapture on IRS worksheets provided with Schedule D, and the process can be a bit complex, but the important point is that depreciation recapture is taxed at rates of as much as 25%.
An example of taxes after you sell an investment property
Let's say that you acquired an investment property 10 years ago and that your cost basis in the property is $150,000. You sell it for net proceeds of $200,000. For simplicity, we'll say that you owned the property for exactly 10 full calendar years (although it rarely works out this easily in practice). We'll say that you're in the 15% long-term capital gains bracket and the 32% income tax bracket. First, you'd have a $50,000 capital gain, which would be taxed as a long-term gain at 15%, coming to $7,500. And then you'd need to pay the depreciation recapture. Over your 10-year holding period, you would have claimed $54,545 in depreciation, which would be taxed at 25%, coming to $13,635. Combining these two adds up to a tax liability of $21,135 on the sale.
How to defer or avoid paying taxes
As you can see from the example, the taxes on the sale of an investment property can be rather high -- especially in cases where you've owned the property for a long time (high depreciation recapture) or sell for a lot more than you paid for it (high capital gains) or both. The good news is that unless you plan to completely cash out and keep all of the sale proceeds, there's a way that you could defer some or all of the taxes you owe through a strategy called a 1031 exchange. The general idea is that if you use the proceeds from one investment property to acquire another, you can defer the tax liability from the first one for as long as you hold the newly acquired property (known as the replacement property). And to be clear, you can use this to defer both capital gains and depreciation recapture taxes. Check out our 1031 exchange page if you want more information, as 1031 exchanges can be quite complex. In order to defer all of your tax liability, the new property you acquire must be equal or greater in value to your original property, and you must adhere to a certain timetable as well as a few other rules. You can also do a partial 1031 exchange if you want to keep some of the sale proceeds and reinvest the rest. However, the takeaway is that as long as you continue to reinvest sale proceeds in more investment properties, you can use 1031 exchanges to effectively defer tax liability indefinitely.
When do you have to pay taxes on the sale?
As a final point, it's important to know when you have to pay any taxes owed on the sale of an investment property. Capital gains tax is assessed during the tax year in which you realized the capital gain. For real estate, this means that any taxes you need to pay on the sale of your investment property are assessed for the tax year during which the sale of the property was finalized. In other words, if you accepted an offer on your investment property in December 2018 but the sale didn't close until January 2019, the income and tax will be included on your 2019 tax return. This means that the tax will be due on April 15, 2020, the date when your 2019 tax return is due. If you close on the sale of a rental property in 2020, taxes will be due on Tax Day in 2021, and so on. It's a smart idea to set aside the taxes you'll owe when the sale closes, so you'll be prepared when tax time rolls around. A qualified tax professional can help you determine the amount to set aside.
With tax issues, defer to the experts
Investment property taxation can be complicated, and there are certainly some grey areas you might encounter when calculating your cost basis in an investment property or your net selling price. And although a 1031 exchange requires an intermediary, they aren't there to give tax advice. The point is that while it's important to know what to expect tax-wise from the sale of your investment property, it's equally important to seek the advice of a qualified accountant or tax professional to guide you through the process.