Investing in a rental property has many tax benefits for a taxpayer with deductions that can offset the income earned, but what happens when that rental is sold? Unfortunately, selling a rental can have the counter-effect and create a tax burden for the taxpayer.
If the property was held for more than a year, and there are gains on the sale that are more than the adjusted basis and amount of depreciation (depreciation gets added back into the gain), then the income is considered capital gains for Federal at most likely the 15% rate and then regular tax rate for State.

Are there ways to avoid those taxes?
Yes! One way is the Section 121 exclusion on the sale of a property; this tax benefit allows up to $250,000 to be excluded for individuals and up to $500,000 for a joint return. The taxpayer must have lived in the property as a primary residence for at least two years out of a five-year period. The two years do not have to be consecutive; they just have to total two years. If this happens, then all the gains (except for depreciation recapture) go into your pocket and none of it into Uncle Sam’s!

For sales and exchanges after Dec. 31, 2008, the rule excluding home sale gain if the two-out-of-five-year rule is met won’t apply to the extent gain from the sale or exchange of a principal residence is allocated to periods of nonqualified use. Generally, nonqualified use is any period (other than the portion of any period before Jan. 1, 2009) during which the property is not used as the principal residence of the taxpayer or spouse. For example, use of a residence as rental property or as a vacation home is nonqualified use.

Nonqualified use does not include:

• Any portion of the five-year qualifying period which is after the last date the property is used as the principal residence of the taxpayer or spouse (regardless of use during that period). (This exception allows the taxpayer up to a three-year period in which to sell the principal residence after moving out of it and still meet the two-out- of-five year requirement);

• Any period (not to exceed an aggregate period of ten years) during which the taxpayer or the taxpayer’s spouse is serving on qualified official extended duty; and

• Any period (not to exceed two years) that the taxpayer is temporarily absent by reason of a change in place of employment, health, or, to the extent provided in regulations, unforeseen circumstances.

An additional way to avoid the Capital Gains tax is through re-investing, Section 1031 “Like-Kind Exchange”. A “like-kind” exchange is the exchange of real property (not a personal residence) used for business or held as an investment simply for other business or investment property that is real estate only (2018 tax law removed the ability to do a 1031 exchange with other types of property). This would eliminate the requirement to recognize the gain because all the proceeds of the sale are wrapped into the new purchase, none of it goes into your pocket as income. If, however, there is an additional gain that goes above and beyond the “like-kind” exchange, then you must recognize that gain and pay taxes on it.
On the other hand, if you happen to experience a loss on the sale of a rental property, it is possible to report a rental loss on sale. The cost basis of a personal residence converted to a rental to use for purposes of calculating a gain or loss is a bit tricky, see blog Personal Residence Converted to a Rental Cost Basis and Sale.
It is wise to evaluate the gains and/or losses on selling a rental property and talk to a tax professional to discuss the best options to maximize your profits before putting it on the market to sale. We are here to help, don’t hesitate to contact our office with any questions or concerns.

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