David T. Mayes
Investing in rental property can provide a financial boost in terms of both higher current incomes and the long-term wealth accumulation that accompanies rising property values. Many young investors are drawn to rental property in order to diversify their income streams. The rental income complements their regular paychecks and can eventually provide an additional source of income for retirement. Rented real estate investments also have some tax benefits as part of the income is shielded from taxation through a non-cash expense in the form of depreciation allowances. In addition, any increase in the value of the property, like any other investment, is tax deferred. That is, the tax is not paid until the sale, and at least under current tax law, the rate for long-term capital gains is lower than the normal income tax rate. With rental properties, however, the story is a little more complicated.
When investors no longer want to be landlords, they are often surprised by the tax consequences of selling their rental properties. This is when the depreciation becomes a tax expense rather than a benefit. With rental property, calculating taxable profit is not as simple as it is with a stock or mutual fund investment by subtracting the net sales proceeds and subtracting the original purchase price. These annual depreciation deductions also reduce the cost base of the property. A lower base means a larger taxable profit on the sale. In addition, the IRS will reclaim a portion of the depreciation benefit and tax a portion of the profit as ordinary income at a maximum rate of 25% under a tax provision known as a depreciation refund. This means that only part of the realized profit receives the long-term favorable capital gains tax treatment.
For example, suppose an investor bought a rental property for $ 300,000 10 years ago. Part of that was the land costs, which cannot be written off. For example, suppose the property was worth $ 50,000 at the time of purchase. This gives the property a depreciable basis of $ 250,000 that will be depreciated over 27.5 years (the time the IRS assumes a rental property will last). This translates into depreciation allowances of $ 9,091 per year, so the adjusted base of the property is $ 209,090 after 10 years. Assuming property prices rise a solid 5% annually, the property will sell for $ 455,000, net of commissions and other selling expenses. This brings the profit to $ 245,910, of which only $ 155,000 is taxed as long-term capital gain. The rest is taxed as ordinary income.
Fortunately, tax law offers some strategies that can be used to reduce, delay, or even eliminate the tax triggered by capital gains and depreciation. One strategy for lowering capital gains tax on rental property sales is to take losses on other investments to offset the profit. However, selling stocks or mutual funds in a broker’s account is unlikely to result in sufficient losses to fully offset the capital gains portion of the rental property sales proceeds.
A second approach is to use Section 1031 of the Internal Revenue Code, which allows for capital gains tax to be deferred if the proceeds from the sale are used to purchase another rental property. This is called a like-for-like exchange. Specific rules need to be followed to ensure a 1031 exchange works as planned, but this can be a good approach for property investors looking to remain landlords.
However, a 1031 exchange only shifts the tax, but does not remove it. In situations where a rental property can be held until the owner’s death and passed on to the heirs, the property’s cost base is redefined, eliminating both the unrealized gain and the recovery of depreciation. The owner’s heirs take the property with a new cost base equal to the value of the property at the time of the owner’s death and, if they keep it as a rental property, begin depreciating the property again on the new cost base.
Converting an apartment into a main residence can also be considered. This would provide $ 250,000 per person exemption from capital gains tax on subsequent sale if ownership and usage tests are passed. While this would lower capital gains tax, the depreciation would still apply to the portion of profit attributable to the previous depreciation of rent.
David T. Mayes is a Certified Financial Planner Professional and IRS Enrolled Agent with Three Bearings Fiduciary Advisors, Inc., a fee-paying financial planning firm based in Hampton. He can be reached at (603) 926-1775 or [email protected].