3 Things You Must Consider Before Selling a Rental Property

People ask me about the taxable gain on selling a rental property all the time, so I wanted to take a minute to outline it for you in this post.

I wish I could tell you this was a cut-and-dried situation. That it was black and white and the pros or cons were the same in every circumstance. Unfortunately…it isn’t that simple. Since you went searching to find this post, you probably knew that already.

Selling a rental property is a big decision for many reasons. You need to consider how your cash flow will be impacted, what it means for your overall goals, and – of course – the tax implications.

There are potentially unexpected tax consequences when you sell a rental property, and it is very important to consider them in advance of the transaction.  There are a few general categories to look at to get you started in the right direction.  Here are the top 3 tax issues from my experience:

Improvements Made

The amounts you have paid for remodels, additions and improvements made in preparation for sale of your rental could impact your tax basis – but not everything counts. Some improvements increase your tax basis (and lower your tax bill) and some do not. Here are some examples from how the IRS considers each:

Improvements that DO increase your tax basis (and lower your tax bill):

  • Additions – Bedroom, bathroom, deck, garage, porch, patio
  • Interior – built-in appliances, kitchen remodel, flooring, carpeting, fireplace
  • Insulation – Attic, walls, floors, pipes and duct work
  • Systems – Heating system, central air conditioning, furnace, duct work, central humidifier, plumbing, septic system, wiring, security system, lawn sprinkler system
  • Lawn & Grounds – Landscaping, driveway, walkway, fence, retaining wall, swimming pool
  • Exterior – Storm windows/doors, new roof, new siding, satellite dish
  • Any of the above improvements made in prior years should already be reflected on your rental depreciation schedule.

Improvements that do NOT increase your tax basis (and do not affect your tax bill):

  • Cost for routine repairs and maintenance (these are deducted as rental expenses on Schedule E in the year paid)
  • Value of your own personal labor or other labor you did not pay for

Depreciation Expenses Taken So Far

Depreciation expense is excellent for reducing taxes while you own the property, but it becomes a taxable item when you eventually sell the rental. Because the property is a business asset, you have likely been taking depreciation on it since it has been in your possession. It is important to know how much depreciation you have taken against the property compared to what you paid for it originally. Typically, the original purchase price is located on the settlement statement (HUD-1) included in your purchase documents.  Normally, depreciation expense is determined each year by dividing the original purchase price by 27.5 years, and total depreciation expense would equal that calculation times the number of years you own the rental. (Note: you should always save purchase documentation to help substantiate cost basis for your property.)

Taxes on the Gain From Sale (If There Is Any)

This is where things really get interesting and very complicated. I have a cheat sheet I provide to clients to help them understand the process because it has so many moving parts. If you would like me to send that to you (and walk you through it) I would be happy to do so. Simply send me an email with the subject line “Selling a Rental Property Cheat Sheet” and I will get it over to you. For this blog, let me just say that there are different tax rates for different portions. It depends on how long you have had the property, whether it is a “Section 1245” property or a Section 1250 property, if Net Investment Income Tax applies or not, if you are filing as Single or Married Filing Joint, closing costs and settlement charges…you get the idea. If there is a substantial gain, a 1031 Like-Kind Exchange should be considered to defer tax on the sale.  That is a whole other topic.

If you are like most people and after reading (or skimming) through the list you thought, “Can you just tell me how this works for my specific situation?” the answer is a resounding yes! And, in general, we recommend you speak to an accountant before taking on a big financial move like this with potential hidden implications and consequences.

Recently, a client came in to talk with us after selling a rental property – and in looking over the documents we saw that if they would have waited and sold 2 weeks later to close the sale it would have been a long-term gain and taxed at 20% (instead of the 37% tax bracket they sold at for a short-term gain). That is heartbreaking for us because the higher tax could have been easily avoided, and I do not want you to suffer the same fate. If you are considering selling a rental property, let’s talk about it first. You could save tens of thousands of dollars in taxes if you understand the tax implications of selling a rental property before you sign the papers, so let’s chat.

Jennifer Roberts

Jennifer Roberts

Jennifer brings to the Hauser Jones & Sas family more than 20 years of experience in the financial industry. Her favorite part of being a CPA is the ability to work directly with people; helping with their tax planning and consulting needs. She has worked with several attorneys to assist with specialized reports required to help resolve legal cases involving partnerships, estates and trusts. Jennifer leverages her past experience as an IRS auditor by representing her clients throughout the entire IRS audit process, allowing her to help resolve numerous issues.