Understanding the Components of Capital Gains
There are two components to taxable gain when you are selling a rental property. First there is the actual capital gain that everybody talks about and then there is something called depreciation recapture which is a little different than capital gains.
First, we need to understand capital gains. Capital gains occur when you sell a property for a higher price than you bought it for. To calculate capital gains, you take the selling price minus your purchase price minus any long-term renovations that you made to the property. From that figure you subtract out any selling expenses, like realtor commissions, etc. The remaining amount is your capital gains. Capital gains are typically taxed at 15% for taxpayers in the normal income range. If you are in the highest tax bracket, then you are taxed at 20%. Keep in mind, this 15% or 20% tax rate only applies if you held the property for longer than one year. If you held the property for less than a year, then you are paying ordinary income tax which is much less favorable.
The other component to a taxable gain of a sale is depreciation recapture. When you purchase a rental property, the IRS requires you to depreciate the property over time because it is considered a business property. If it is your primary home, you do not have to worry about depreciating it because you are not using it for business. Now if you rent out a room in your house, let’s say as an Airbnb, then you would depreciate a portion of your house over time. The allowable depreciation deduction is $10,000 annually. So, let’s say you pay $270,000 for your rental property, you’re expected to depreciate that rental property at $10,000 per year over a period of 27 years. If you bought the rental on the first day of the year in 2020, you would depreciate $10,000 on your 2020 tax return. For 2021, you would depreciate another $10,000. So now you have a total of $20,000 of depreciation over the two-year period.
Depreciation recapture means that if you sell the property for greater than what you purchased it for you must take your total depreciation deduction and pay taxes on that depreciation as a “recapture”. While you are renting the property out, you are taking this depreciation deduction as an offset against your income. It is offsetting your rental income, and in some cases could offset your ordinary income as well. When you sell the property for more than the purchase price, you then must pay taxes on the depreciation recapture. The tax rate on depreciation recapture is up to a maximum of 25%. Oftentimes your ordinary income is taxed at a higher rate than 25% so paying the depreciation recapture tax is not a total wash.
Strategies to Minimize Your Capital Gains/Depreciation Recapture Taxes
Now that you understand the two components of taxable gains when you are selling your rental property, let’s talk about strategies on how to minimize your capital gains or depreciation recapture taxes. There are three primary methods that you can use to minimize capital gains taxes. Those methods are the 1031 exchange, holding your property until you die, and Section 121 exclusion.
The 1031 exchange means that you have your business property and instead of selling it and paying capital gains on it, you take that business property, and you exchange it for another property. At the time of the exchange, you do not pay any capital gains tax. You are not actually avoiding capital gains; you are just deferring it. You are moving any capital gains that you would have paid on the original property to your new property and then you are continuing to depreciate it. This is an effective way to “move up” in property without paying capital gains tax immediately. A 1031 exchange covers capital gains and depreciation recapture. For the 1031 exchange to work, you must go through a qualified intermediary that handles 1031 exchanges. The money that you get from selling your first property gets put into a trust account and then you must have identified some other properties that you want to purchase within a specified period. Make sure you engage with a 1031 exchange specialist to do this. Check with your real estate agent or your title company to see if they know somebody that handles 1031 exchanges if this is something you are interested in doing.
The second way to avoid capital gains taxes is to hold on to your rental property until you die. The person who inherits the property will then get a step up in basis. Now what does that mean? Your original purchase price is your cost basis, if you die and you will that property to someone, that person gets a step up in basis at the time of your death. Which means that the home’s cost basis gets “reset” to the current home value rather than the original purchase price. So how is this avoiding capital gains? Let’s say you bought a property 20 years ago in Denver and your purchase price was $50,000. In the current market, that property is worth $1.5 million. That property would have considerable capital gains taxes if it were sold by the inheritor if there was no step up in basis. With the step up in basis, when they sell it immediately for $1.5 million, they are taking the selling price of $1.5 million minus their (step up in) basis which is also $1.5 million and thus there are no capital gains to pay. In this case, the inheritor is the one that has the tax benefits, not necessarily you. If you are looking for estate planning or generational wealth building, this is one way to do that. One common mistake that people make is thinking that the step up in basis is automatic, and that is not true. You must file Form 706 which is an estate tax return to tell the IRS that this property is receiving a step up in basis and what that new basis is at the time of death. So, some forms must be filed with the IRS for this to work. It is important when you are planning for your estate or when a family member passes away to get in touch with the estate planning attorney and a good CPA to make sure that all those things happen correctly.
The third way to avoid capital gains tax is the Section 121 exclusion. And this is more commonly known among people who just own primary residences. It is the rule that says if you lived in a home as your primary residence for at least two out of the last five years, then you can exclude up to $250,000 of capital gains per person. That means if you are married you can exclude up to $500,000 of capital gains. This prevents people from paying a bunch of capital gains tax for just wanting to move their family. How does this tie into rental real estate? One thing that people might do is they might move into their rental property for a couple years as their primary residence and that way a married couple can exclude up to $500,000 of capital gains on what was their rental property but has become their primary residence. Now this method does not include depreciation recapture tax. So although you might exclude capital gains, you still have to pay taxes on the depreciation recapture. This is something that accountants commonly misreport. Make sure you hire a good CPA if you plan to use this strategy. Remember to mention that there has been depreciation taken on this property and you want to make sure it is accounted for correctly. This strategy would make sense if you have had the property for a long time, it has appreciated in value significantly, and moving into it as your primary residence is feasible for your family.
Keep in mind that with a business property, the IRS wants to make sure you rent out a property for at least one year before you move into it as your primary residence. This is important if you choose to do a 1031 exchange into a new property or if you plan to use the Section 121 exclusion. The 1031 exchange is the exchange of a business property for another business property, so you cannot exchange it for a personal residence without raising some suspicion. You are exchanging one business property for another business property so you should wait as long as possible before moving into that property to avoid any trouble with the IRS. To summarize, there are three ways to avoid capital gains, the 1031 exchange, holding the property until you die, and moving into your rental property and living in it for at least two out of five years.
Many of our clients who have done their own taxes on Turbo Tax have run into the problem that Turbo Tax did not take the depreciation on their rental property. The IRS requires you to depreciate your property if it is a rental or if it is used for business purposes. When you go to sell the property, the IRS will require you to pay depreciation recapture tax even if you did not take the depreciation over the years. In this case you did not get the benefit of the depreciation deduction on the front end and are now having to pay the taxes for it on the back end. There is a way to get out of this, it is called the Change of Accounting Method. This basically takes all of your missed depreciation and lumps it into the year that you sell the property. This offsets the depreciation recapture and is filed with Form 3115.
We are here to help. If you need assistance in determining how to minimize your capital gains taxes or need to have a Form 3115 completed to offset that depreciation recapture, reach out to us at www.nguyencpas.com or firstname.lastname@example.org and schedule a complimentary consultation with one of our advisors.