David T. Mayes
Rental property investing can provide a financial boost both in terms of increased current income and the long-term wealth creation that comes with rising property values. Many young investors are attracted to rental properties to diversify their income streams. The rental income supplements their regular paychecks and eventually can provide an additional source of retirement income. Rental property investments also have some tax benefits in that some of the income is sheltered from tax by a non-cash expense in the form of depreciation deductions. Also, any growth in the value of the property accrues on a tax-deferred basis like any other investment. That is, tax is not paid until you sell, and, at least under current tax law, the rate applied to long-term capital gains is lower than ordinary income tax rates. With rental properties, however, the story is a bit more complicated.
When investors no longer want to be landlords, they are often surprised by the tax consequences of selling their rental property. This is when depreciation becomes a tax cost rather than a benefit. With rental properties, computing the taxable gain is not as simple as taking the net sale proceeds and subtracting the original purchase price like you would with a stock or mutual fund investment. Those depreciation deductions taken each year also reduce the property’s cost basis. Lower basis means a larger taxable gain on the sale. Moreover, the IRS will want some of the depreciation benefits back and will tax part of the gain as ordinary income subject to a maximum rate of 25% under a tax provision known as depreciation recapture. That is, only part of the realized gain receives the favorable long-term capital gain tax treatment.
For example, suppose an investor purchased a rental property 10 years ago for $300,000. Part of this was the cost of the land which cannot be depreciated. Assume the land was worth $50,000 at the time of the purchase. This gives the property a depreciable basis of $250,000 which will be written down over 27.5 years (the amount of time the IRS assumes a rental property will last). This means depreciation deductions of $9,091 annually making the property’s adjusted basis $209,090 after 10 years. Assuming real estate prices increase a solid 5% annually, the property sells for $455,000 net of commissions and other selling costs. This makes the gain $245,910, but only $155,000 of this is taxed as long-term capital gain. The rest is depreciation recapture taxed as ordinary income.
Fortunately, the tax code provides a few strategies that may be used to reduce, delay, or even eliminate the tax triggered by both capital gain and depreciation recapture. One strategy for reducing the capital gain tax on a rental property sale is to harvest losses on other investments to offset the gain. However, selling stocks or mutual funds in a brokerage account is not likely to generate enough losses to completely offset the capital gain portion of the rental property sale proceeds.
A second approach is to use Section 1031 of the Internal Revenue Code which allows capital gains tax to be deferred if the sale proceeds are used to purchase another rental property. This is known as a like-kind exchange. Specific rules must be followed to ensure that a 1031 exchange will work as planned but this can be a good approach for those real estate investors who want to remain landlords.
A 1031 exchange, however, merely defers the tax, it does not eliminate it. In situations where a rental property can be held until the death of the owner and passed along to heirs, the cost basis of the property gets re-set, eliminating both the unrealized gain to that point and the depreciation recapture. The owner’s heirs will take the property with a new cost basis equal to the property’s value on the date of the owner’s death and, if they retain it as a rental, start depreciating the property again based on its new cost basis.
Converting a rental to a primary residence might also be considered. This would make the $250,000 per person exclusion from capital gain tax available on the subsequent sale if the ownership and use tests are satisfied. While this would reduce the capital gain tax, depreciation recapture would still apply to the part of the gain attributable to prior depreciation of the rental.
David T. Mayes is a Certified Financial Planner professional and IRS Enrolled Agent at Three Bearings Fiduciary Advisors, Inc., a fee-only financial planning firm in Hampton. He can be reached at (603) 926-1775 or david@threebearings.com.