There comes a time in every real estate investor’s career when they consider selling a rental property they own. Perhaps the investor is ready to retire from being a landlord. Maybe there’s a large capital expenditure on the horizon, such as a roof that needs to be replaced. Or maybe you own a vacant rental property and are having a difficult time finding a tenant. Whatever your reason is for selling a rental property in Pittsburgh, you should be prepared for the tax consequences.
Today’s article will focus on one specific type of tax: the capital gains tax. Specifically, we’ll discuss what the capital gains tax is, and ways you can minimize taxes when selling a rental property.
What is the capital gains tax?
The capital gains tax applies to individuals who sell an asset for greater than their basis in that asset. What does “basis” mean, you may ask? The basis of an asset is simply what you paid for it, plus any improvements you made to the asset. For example, if you buy a stock for $45 and sell it 2 years later for $50, the IRS will recognize your “basis” as $45. In real estate, it’s a little more complex.
Cost Basis and Capital Gains Tax in Real Estate
There are two “basis” types required to calculate the amount of capital gains earned on the sale of real estate. Here are some key formulas:
Ending Basis = Selling price of property – selling costs
Adjusted Basis = Price paid for property + capital improvements – depreciation
Capital Gain = Ending basis – adjusted basis
For example, let’s say you think you can sell your rental property today for $100,000, and that closing costs associated with selling it would be equal to $3,000. Your End basis would be $97,000. Let’s also say you paid $50,000 for this property when you purchased it, and spent $20,000 in capital improvements. Over the course of ownership, the property has also depreciated by $10,000. Therefore your adjusted basis would be $60,000. This means your overall capital gain would equal $40,000. This is the amount subject to the capital gains tax.
Basis is an important concept when it comes to capital gains. The greater the difference between your adjusted basis and end basis, the more you will pay in taxes. This makes sense, because it means the more profit you make on an investment, the more taxes you will have to pay.
Are There Different Types of Capital Gains Taxes?
The answer to this question is: yes. There are two types of capital gains:
- Short-term capital gains: These are gains realized on assets that have been held for less than one year. Short-term capital gains are taxed at the same rate as your ordinary income tax rate. If you are someone who “flips” real estate, you may fall into this category.
- Long-term capital gains: These are gains realized on assets held greater than one year. The IRS incentivizes this type of behavior and taxes these gains at more favorable rates (between 0% and 20%, depending on your income).
Because most real estate investors hold their assets for longer than one year, we will focus specifically on the strategies to help minimize long-term capital gains taxes when selling a rental property.
Strategies to Help Minimize Taxes When Selling a Rental Property
1. Take Advantage of a 1031 Exchange
In most areas of Pittsburgh, property values have increased since the peak of the recession in 2009. That said, if you have owned a rental property in Pittsburgh for several years you likely have equity in the property. Another way of saying this is that you will likely owe some amount in capital gains tax, as your property has gone up in value over time.
One popular strategy for avoiding this is the 1031 exchange. A 1031 exchange gives taxpayers an opportunity to defer, but not avoid, capital gains taxes when selling an investment property. There are two primary conditions for a 1031 exchange:
- You must reinvest the money in a like-kind investment (i.e. another investment property)
- You must purchase that investment within 180 days of selling your existing investment
Done correctly, this strategy allows investors to continue reinvesting their gains tax free for many years. Keep in mind however, that this is a tax deferment strategy, so taxes will ultimately have to be paid when you sell a property and do not purchase another like-kind investment.
2. Keep Track of Your Property Selling Expenses
Without a doubt, you will have some expenses if you choose to sell your investment property. The costs of selling an investment property include advertising costs, real estate agent’s commissions, document preparation fees as well as escrow and closing costs. You should keep track of these expenses, as they help to reduce your end basis, thereby reducing your overall capital gains tax liability.
3. Records for Capital Improvements Can Help You Reduce Capital Gains
Have you done any of the following throughout your time owning your Pittsburgh rental property:
- Remodel a bathroom or kitchen
- Add rooms to a building
- Replacing floors
- Replace windows
These are all considered capital improvements. Why is this important? Because capital improvements increase the basis of your property, meaning it will lower the amount of taxes you have to pay when you sell it. Hopefully you or your accountant have been tracking these throughout the course of ownership, as this can make a significant difference when it comes time to sell your property.
4. Reduce Your Taxable Income
As we mentioned in the beginning of the article, your long term capital gains tax rate can be between 0% and 20%. Your specific capital gains tax rate depends on your income. If your taxable income is between $39,376 – $434,550, you will be taxed at 15%. If you earn more than $434,550, your capital gains tax rate will equal 20%. Therefore, it may be wise to maximize your allowable deductions prior to filing your tax return. Things like making a charitable contribution or funding certain types of retirement accounts are examples of activities that may help to reduce your taxable income.
5. Owner Finance Your Property
We have a separate article on the benefits of owner financing your property to a prospective buyer, so we won’t go into the details in this article. At a high level, this strategy entails the rental property owner financing the purchase of the property for the buyer. In turn, the buyer pays the rental property owner equal payments over time, just like they would to a bank. As the owner, you are essentially acting as the bank. You will receive monthly payments for an agreed upon period of time and earn interest on that money. This prevents you from receiving a large lump sum in one year, and causes more of the gain to be recognized as interest income instead of a taxable capital gain.
Selling a Pittsburgh Rental Property? We can help!
Are you interested in selling a rental property in Pittsburgh? Do you have a portfolio of properties that has appreciated significantly, and are concerned with the amount of taxes you may owe when selling them? At McIntosh Management, LP, we work with rental property owners in Pittsburgh to find win-win solutions that can help rental property owners minimize their taxes when selling a rental property. Give us a call today at 412-785-7928 to learn more, or fill out our form below to receive a call from someone on our team who can help with your unique situation.