Owning a rental property can be both rewarding and lucrative. When you unload your rental property, you may face tax consequences. The tax man always has his hand out when people have been success in investments. With this in mind, there are several rules you need to keep in mind when trying to figure out how much tax you will owe on the rental property at the time of sale. In most cases, you will owe money when you cash in on that investment. How much you will owe depends on how you handled the property, how much money you put into it and how much you paid in selling costs.
Defining rental property
While the tax code provides a $250,000 per person tax exemption for gains made on your primary residence, this does not apply if you’re selling a rental property. A rental property is defined as a residence where you don’t live. This means that if you have a vacation home or a second home, you’ll owe taxes if your sale represents a gain. However, if you do live in the home for two years prior to selling it and you have owned it for five or more, you can claim some of the deduction. This is ideal for people who once treated their property as a rental before deciding to move into it.
Calculating capital gains tax
The capital gains tax rate is 20%, which means you will generally pay that rate on whatever you have gained from the sale. Figuring out what you have gained can be somewhat tricky.
The first thing to do is figure out your basis in the home. This includes what you paid for the home and any improvements you have made. Think, for instance, about the couple that buys a rental property for $200,000 in 2010. Over time, they put in a new kitchen, renovated the bathroom and added that fancy man save that everyone has been dreaming of. They updated the countertops, put in new wooden floors and built an over the garage apartment. These improvements cost roughly $100,000. This means that the couple has a $300,000 basis in the home.
The next step is to calculate the sale price properly for tax purposes. Imagine in the scenario above that the couple was able to find a buyer for $400,000. They have done quite well, netting a true $200,000 gain from purchase to sale. However, they have an additional $100,000 in improvements to add to the basis. On top of that, they had to pay $8,000 in selling costs, plus a $15,000 payment to the real estate agent who sold the home. This means that the sale price will be reduced by $23,000, leaving them with a taxable gain of $77,000.
Unless they are able to exempt some of that income, they would owe 20% on this figure, bringing the total to $15,400 in owed taxes. These taxes are unavoidable, and they become more complicated if the couple happened to take depreciation on the home from their earlier tax returns. If that is the case, then the government may be able to “recapture” some of that depreciation as ordinary income in the year of the sale.