Top-3 Takeaway: Selling Your Rental Property
Ed Jones, CPA, discusses with the FOCUS on NoVA Real Estate team the complicated nuances to consider when it is time to sell your rental or investment property. For more information contact the FOCUS on NoVA Real Estate team today.
Ed Jones, CPA is a tax accountant for the FOCUS on NoVA Real Estate team members, as well and advisor to our clients when we have tax questions. In the age of COVID-19, lots of folks started buying second homes and are unloading rental properties. As they navigate what they are doing so we get tax questions all the time about the implications of selling rental properties. The Top-3 Takeaway today is “Selling your rental property and your need to know and what you need to know”.
Per Ed, “Selling a rental property has obvious huge tax implications when you sell. What happens when you sell a rental property? What does a poor CPA like me have to do in order to figure out what the tax implications are going to be? Number one, it all starts with what’s your gain from this sale the sale of a rental property? The sales price is obvious, it’s what the person’s buying it for. You subtract you’re selling expenses which includes your commissions and all the other expenses that are on the settlement sheet, plus everything you spent to get the property ready to sell. You then get to subtract from that to get to your gain your basis in the property and this is where everything changes.
“When you have a rental property your basis in your rental property is what you originally paid for it, plus the improvements you’ve made to it, minus the depreciation you took, or should have taken, on it for tax purposes. Depreciation is a special thing. It’s an accounting term that means the wasting away of a physical asset. You buy a $300,000 house you don’t get to take a $300,000 deduction against the rental income the first year. Instead every year you get to take a portion of that $300,000 as an expense, usually over 29 1/2 years. But it all depends on the type of property.
“Every year you have to take this deduction. It is one of the reasons rental properties are what’s considered a tax shelter because often in the first few years of a rental property your deductions are larger than the actual cash flow you have going out. What you have to take as depreciation on your rental property, for purposes of a sale to determine what your basis, is mandated by the IRS. You can’t choose to not take the depreciation. This means that if you made a mistake in a previous year and didn’t take the depreciation, you can end up in a situation where you pay tax on that even though you never took the deduction.
“So for instance, I have a client looking at selling a rental property they bought this property back in 2003. I just finished going through 16 years worth of tax returns to catch every single depreciation they took to make sure it was the correct amount. I checked to make sure we didn’t miss any, and on one of the years they didn’t take the depreciation by accident. That means in the final year I get to add that back in, as long as I’ve realized it’s happened.
“It’s really important when selling a rental property to have good records and have kept these tax returns for all those years. In addition, real estate rentals often create a loss. Rental property is considered a passive activity by the IRS. This means you can only take that loss each year if you have other passive income to offset it, or if you’ve sold the property. Oftentimes you’ve been taking this depreciation, all the other expenses related to this rental property, cheerfully deducting them in your tax return, appropriately and properly, and not being able to take the deduction.
“The clients I just talked about over that 17-year period had nearly $250,000 of losses that they couldn’t take and they were being carried forward in their tax return. This means that when my client was selling the property, they had almost a $200,000 gain, all of which was essentially depreciation, which means it gets taxed at a slightly higher rate when you recapture it. In the end, they’re going have $200,000 of gain being taxed at roughly 25%. At the same time they got to harvest $250,000 of losses they weren’t allowed to take, and they’re actually ending up saving nearly $15,000 in taxes by selling this property. It is because they never got to deduct it. This all starts from doing the returns properly and keeping them so you can track it when you sell it later on.
“If you end up with a large gain, there are ways to avoid the taxation, legitimately and properly, by doing tax free exchanges into additional rental properties or investment properties. This is a sophisticated piece you really need a professional to walk you through it. I highly recommend you talk to your tax advisor about it. The main takeaway is it is critical to keep your tax returns and to keep information related to your rental and investment properties, so that someone like me can rebuild what happened and potentially save you lots of money in taxes – or make you pay lots of money in taxes. But you’d rather we do it than in a couple years later the IRS figures it out and hits you with penalties.”
This is only the tip of the iceberg on this tax code. It is long and complicated and when it comes to rental properties there’s so many nuances to get into. This is why it’s so important to work with a tax professional when you have rental properties. If you have personal questions about your own rental properties, or you’re considering getting into the rental market, please reach out to the FOCUS on NoVA Real Estate Team today.
