If you own a rental property (and live there, too) you have 2 fantastic opportunities to reduce taxes on capital gains when selling a rental property.
Many people have made the decision to convert a portion of their home into a rental unit. Perhaps their children went off to college, and instead of downsizing, they converted the upstairs or downstairs floor into an apartment. If you’re interested in this process, check out this how-to article on converting your home into a rental.
While monthly income along with deductions for depreciation and property improvements are major benefits of turning your residence into a rental, the downside reveals itself when it comes to selling your rental property.
Without making 1 of 2 strategic tax moves – a 1031 Exchange or investment in a Qualified Opportunity Zone (QOZ) – you’ll be taxed on 100% of the capital gains when selling a rental property. Of course, that doesn’t count the portion of your home used as your principal residence, but more on that later. First, let’s take a closer look at how the IRS views selling a rental property that’s also used as a primary residence from a tax perspective…
Example: Peter and Sasha Are Selling a Rental Property Where They’ve Also Lived for 30 Years
Thirty years ago, Peter and Sasha purchased a large home for $100,000. After living there for a few years, they realized they rarely used the walk-in, fully finished basement and part of the first floor. They decided to convert this half of their home into a rental property.
Now, Peter and Sasha are selling their rental property and home – and they’re panicking at the tax implications! Here’s why. Today, their residence is worth $1 million dollars. Because they have a rental property – which is considered a business – they are afraid they’ll need to pay taxes on their capital gain of $900,000 ($1 million selling price today minus $100,000 initial investment 30 years ago. This ignores, for now, prior depreciation and depreciation recapture rules).
But Peter and Sasha instead meet with a CPA firm well-versed in selling a rental property, like Robert P Russo CPA, and learn that they’ve got options…
Relax, When Selling a Rental Property That’s Also a Residence, You Can Still Benefit from the “Principal Residence Gain Exclusion”
That means you won’t pay taxes on capital gains from the sale of your principal residence up to $250,000 (filing single) and $500,000 (filing jointly). That’s assuming you meet certain basic requirements, such as living in your current principal residence for 2 out of the past 5 years.
Since Peter and Sasha occupy half the house, they divide the capital gain of $900,000 by 2 to get $450,000. They apply the “principal residence gain exclusion” and presto, they’ve eliminated half of their tax burden.
But what about the $450,000 capital gain from selling their rental property?
This is where you can be strategic, or miss out on thousands in tax savings.
If Peter and Sasha went ahead with selling their rental property, without thinking ahead as to what they would do with the capital gains, here’s what could happen. Prepare to be shocked…
First, Peter and Sasha would pay capital gains tax on the $450,000 at the current rate of 23.8%. So that’s a hefty $107,000 in taxes. Plus, they’ve fully depreciated the house over 27.5 years. So they’d also be taxed at 28.8% on $50,000 (the initial purchase price on the business portion that was depreciated is now taxed at a different rate) which would be $14,400. Then they would also pay income tax to their state of residence.
But what if Peter and Sasha could make all these taxes disappear or at least be deferred? It’s possible, legal, and the smart thing to do. Peter and Sasha can still move forward with selling their rental property if they select from the following two options: a 1031 Like-Kind Exchange or investment in a Qualified Opportunity Zone.
How a 1031 Like-Kind Exchange Can Ease the Tax Burden of Selling a Rental Property
This is part of the tax code that basically says that you can defer capital gain taxes on the purchase of a property used for investment or business purposes, if the property you are “exchanging” is also going to be used for a similar purpose. In Peter and Sasha’s case, the business portion is the rental property. So, if they want to defer their gains from selling their rental property, they’d need to reinvest those gains into another rental property (hence the term “like-kind” exchange).
There are a few caveats for ensuring the 1031 like-kind exchange meets IRS requirements. First, the cost of the new rental property they purchase must be equal to or greater than the amount of their current property sold. And the mortgage they get on their new property must also be equal to or greater than any mortgage they have on the property they are selling. So Peter and Sasha must find another rental property that’s at least $450,000.
After they’re have sold their rental property, the capital gains must go directly into the next rental property via a qualified intermediary. Any cash on the sale cannot be touched by them including the downpayment.
Still, these are small hoops to jump through when you consider they are deferring capital gains taxes of over $120,000! And these deferments can happen indefinitely, so Peter and Sasha can go through life without having to pay capital gains taxes from selling their rental property.
Of course, with tax savings this good, you better believe the IRS has even more stipulations. For example, you have just 45 days to identify the new property you want to exchange – and then a max of 180 days to make the exchange.
The laws here are fairly complicated, and we have given you only a brief overview.
You must work with a qualified CPA to undergo this process, or risk an audit or tax penalties instead of tax savings. Many of us here at Robert P. Russo CPA have helped people through the complexities of a 1031 Like-Kind Exchange, so get in touch with us if you have any questions.
Your Other Option is to Invest in a Qualified Opportunity Zone (QOZ)
So, what exactly is a QOZ? There are over 9,000 of these zones throughout America. They are low-income areas where the U.S. government hopes to attract investment through significant tax benefits for investors. We’ve prepared a QOZ 101 guide to help get you acquainted with this exciting tax program.
When it comes to selling a rental property and having a capital gain, a QOZ fund gives you an opportunity to defer and reduce taxes on those gains. While a 1031 Exchange only works for business-related real properties, you can invest almost any type of capital gain in a QOZ fund.
Back to Peter and Sasha. After selling their rental property, they decide to invest their $450,000 capital gain into a QOZ fund. If they do so by 2021, they can defer paying taxes on the gain until 2026. At that point, their capital gain will also be reduced by 10%! So, they’ll only be paying taxes on $405,000 instead of $450,000.
Now, let’s say that in 2026, Peter and Sasha decide to hang onto their fund because it’s performing well – their initial $450,000 investment is now worth $650,000. In 2026, they still get their 10% gains reduction. But they get something even better: If they hold onto their investment for 10 years total, they don’t have to pay taxes on that additional gain of $200,000. Yes, any gains made in a QOZ fund are tax free!
Just like the 1031 Exchange, there are strict rules you must follow. You have 180 days to reinvest from the date the original capital gain would have been recognized (so likely, from the date of selling your rental property).
Again, don’t try to navigate the QOZ landscape alone. You must reach out to a CPA firm. As we’ve said before, all of us here at Robert P Russo CPA are ready to answer any questions you may have. So if you’re selling a rental property, discuss your options with us today.