If you have investment property, such as residential real estate, that you rented and reported for tax purposes and now you wish to sell the property, you should be aware of the tax implications on selling investment property before you price the property for sale.
When you sell your primary residence, calculating your basis in the property is usually as simple as determining the price you paid for the property and adding the cost of capital improvements to that amount, but determining the basis on investment property is a bit more involved. When you filed your tax return to report rental property activity, you claimed depreciation on the property and any capital improvements made to the property. The first tax implication on selling investment property is that you must reduce your basis in the property by all depreciation previously claimed on tax filings. If the property has appreciated in value and/or you have rented the property for some length of time, the reduction in basis due to depreciation can make a significant difference in your profit from the sale.
To calculate your basis in investment property, use the following equation:
- Original purchase price of the property
- Plus closing costs on the purchase (real estate commissions, legal fees)
- Plus capital improvements (roof, fence, AC replacement)
- Plus costs to sell the property (real estate commissions, legal fees)
- Less total depreciation claimed for the investment property on prior tax returns
The sum of these equal your basis investment in the property.
Once you've established your basis in the investment property, you can calculate your gain on the sale.
Capital Gains and Recapture Tax
Once you’ve established your basis in the investment property, you’re one step closer to determining the tax implications on selling investment property. The next step is to calculate your gain on the sale, which simply requires subtracting your basis in the property from the selling price you gained on the sale of the property. For example, if your basis in the property is $150,000 and you sell the property for $200,000, then you have a gain on the sale of $50,000, but all of the gain is not reported as a capital gain due to the rules surrounding depreciation recapture. The amount of depreciation claimed on the property is recaptured at the sale of the property and taxed at a fixed rate that is currently 25%.
For example, if you claimed $20,000 in depreciation on the sold property in prior tax filings, you will owe $5,000 in tax due to the depreciation recapture alone. The remainder of the gain on the sale is taxed at your individual capital gains rate, which depends on your other income and investments.
Before You Sell
Before you set a selling price for the property, you should estimate the tax implications on selling the investment property, especially if the investment property is secured by a loan. If you wish to sell the property to purchase something else or pay off another debt, you may pocket far less cash than you imagined because of the tax due on the sale.