What taxes will you pay on the sale of rental property? (and how to minimize them)
Published July 8, 2022Share this article
Thinking about selling your rental properties? If you’ve owned them for a long time, you’re probably worried about the value you might lose to taxes. In fact, the average U.S. rental property that's been owned for 25 years will lose a third of its value to taxes when it's sold.The good news: there's a great way to defer and minimize those taxes. We'll cover 2 significant sources of tax liabilities, capital gains and depreciation recapture taxes, how they work, and explain strategies investors like you can use to minimize taxes and preserve value.
High-income taxpayers may also owe an extra 3.8% net investment income tax, whether they have a short-term or long-term gain.
Capital Gains Tax
If you sell an investment for more than you paid for it, you'll have a capital gain. For example, say you buy a rental property for $200,000 and sell it years later for $300,000; you'll realize a capital gain of around $100K. The capital gains tax is the tax on that $100K gain.To precisely calculate your capital gains, you need two numbers: the cost basis and the net proceeds. The cost basis is what you paid to get the property — including buying it, some closing costs, appraisal fees, and legal fees — plus any major improvements. The net proceeds are what you make from selling it — less any associated costs like real estate agent commissions, home staging, house cleaning or lawyer fees.Subtract the cost basis from the net proceeds to calculate your rental property's capital gain (or loss).You'll be taxed on those gains at different rates depending on how long you've owned the property, your filing status, and your taxable income.- Owned property for less than one year: Gains are considered short-term gains and are taxed as ordinary income (capped at 37% for 2023).
- Owned property for more than one year: You’ll pay 0%, 15%, or 20% (for 2023) in taxes, depending on your filing status and taxable income — see the chart below for the official 2023 capital gains tax rates from the IRS.
High-income taxpayers may also owe an extra 3.8% net investment income tax, whether they have a short-term or long-term gain.Depreciation Recapture Tax
As a rental property owner, you most likely take a depreciation deduction. Most rental property is depreciated over 27.5 years — what the IRS considers its "useful life" (the value of the land doesn't get depreciated because it isn't used up). That means you can deduct 3.636% of your cost basis each year, which can be a nice perk at tax time every year.Of course, the IRS remembers those deductions and wants some of that money back when you sell. This is where the depreciation recapture tax comes in. The tax applies to the amount of gain that can be attributed to your depreciation deductions while you owned the property. The current federally mandated tax rate is 25% (2023).Even if you haven’t been taking the deductions, the IRS will still want to recapture the amount you should have deducted, whether you actually did or not.How to Defer and Minimize Taxes
If you've owned multiple properties for many years, you can probably tell by now you’re on the hook for hundreds of thousands, or even millions, of dollars. How can you control and minimize your tax burden?The 721 Exchange
Enter Section 721 of the US Internal Revenue Code, also known as the 721 Exchange. This transaction defers capital gains taxes and depreciation recapture taxes and enables you to minimize those taxes. In this transaction, landlords swap their properties for roughly equivalent value in an operating partnership,such as Flock's fund containing a fully-managed portfolio of real estate assets similar to — and including — yours. The fund continues providing you ongoing income, access to potential real estate appreciation, and continued depreciation from the portfolio, without the need for you to actively manage it. Because you own shares, you can flexibly liquidate your equity for cash — whether that's in parts or all at once.But at some point, you’re still on the hook for capital gains taxes when you liquidate, right? Yes and no. You still pay capital gains taxes when you redeem your shares for cash, but the shares let you control when you sell. That way, you can spread out your capital gains tax burden over time. For example, selling a whole property worth $300,000 might incur a higher average capital gains tax rate than if you sold $50,000 worth of shares each year for a couple years, because of the annual taxable income that you are generating from each sale.Furthermore, Flock shares benefit from a step-up in basis. Upon your death, the cost basis (off of which the taxable gain is calculated) resets to the current value of the shares, meaning your heirs are no longer liable for the gains that you made during your lifetime. If you’ve made significant gains on your real estate, these savings can be massive for you and your family.You're probably wondering why you haven’t heard of the 721 Exchange before. For decades, it’s been almost exclusively used by Wall Street institutions to defer taxes for their wealthy clients. Flock Homes was the first to make it accessible and seamless for individual real estate investors like you.The 1031 Exchange
How does this compare to the 1031 Exchange? The 1031 Exchange similarly allows you to defer capital gains and depreciation recapture taxes, but instead of directly exchanging your home for ownership in a fund, you sell your property, receive tax-deferred proceeds, and use the proceeds to purchase another investment property. Many investors who want to remain active investors commonly use it to switch up their investments in a tax-advantaged way.However, keep in mind, it’s a more complicated transaction - involving at least 2 closings, intermediary parties, and stringent timelines that could jeopardize your tax-deferral benefits. You’ll also remain an involved manager of your individual homes, and may not have the same flexibility to liquidate or spread out your tax burden over time (you can't sell just one-third of a home!).Comparison of tax-deferred exchanges
Summary
You've spent decades building your real estate wealth - don't throw it away now. If you're looking for a permanent exit strategy that gives you the ultimate flexibility to control your liquidity and tax strategy, consider the 721 Exchange. If you're looking to remain an active investor but switch up your investments in a tax-advantaged way, consider the 1031 Exchange.In an industry-first, Flock Homes is combining tried and true industry expertise with technology to provide individual landlords seamless access to the 721 Exchange. Over 100 real estate investors have entrusted Flock Homes to help them save millions in capital gains taxes. Get started now with a completely free valuation of your property to see how much you could save, or click below to request a free webinar to learn more.Landlords, retire and minimize taxes.
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