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Minimizing taxes when selling a rental property

Real estate investing

Finding a single-family residential (SFR) investment property can be a challenge, whether it be finding the right market to picking the right home to finding the right moment to buy. 

But selling a rental property can be equally challenging, especially if the house has appreciated and the sale creates a tax liability. 

There are several strategies sellers can use to avoid paying capital gains taxes on a property they’re selling, including executing a 1031 exchange, offsetting gains with losses, or taking advantage of the primary residence exclusion. 

What to keep in mind when selling

“The first question is, When is a good time to sell an investment property?” says Kemi Olanade, listings program manager for Mynd. “You want to factor in a lot of things. In terms of the home itself, if you’ve done some work on the property, it may be worth more than what you paid for it, and the buyer may be able to increase the rent, which most buyers might want to do.”

Selling a vacant property is relatively simple, but putting a property that already has a tenant in it on the market can be a little more complicated. 

But it’s not necessarily a bad thing. 

“Are the residents paying their rent on time?” says Olanade. “Are they long-term or short term? If the residents have been there for 5 or 10 years and pay the rent on time, that could be appealing to a buyer.”

Real estate properties that are sold ready-to-rent or with tenants already in place — so-called turnkey properties — allow an investor to earn rental income from day one. 

Residents who have a history of problems can pose complications. 

(After all, it’s rare to list a home in need of “some TLC” and with a tenant with no lease living in the basement — which the buyer wasn’t allowed to see — and yet see it quickly sell for over the $800,000 listing price, as happened in April with a home in desirable Fairfax, Virginia.)

It isn’t always a simple matter to get a tenant to vacate. As the saying goes, it has a lot to do with location.

“It may depend on which state the property is in,” says Olanade. “In some states, the laws are very favorable to the tenant, while others are more landlord-friendly.” 

States like California are slanted in favor of the tenant, she says, while property owners find that the laws in states like Texas or Florida favor them.

Investors who want to sell a property with a tenant in place are faced with the choice of either waiting until the lease is up to sell; offering the property to the resident; or paying the resident to leave. 

If the resident is unable to get a conventional loan, the seller may wish to finance the purchase themselves. Seller financing is typically offered for a short period of time, until the buyer can obtain a traditional mortgage.

Mynd has a sales operation, and the company leverages local agents, networks, and infrastructure in 25 markets, plus big data models and comps, to ensure the maximum possible sale price — whether from another Mynd investor or a prospect in the local market.

How to avoid a tax bill on a property sale

Investors selling a property that has appreciated in value face the prospect of paying capital gains taxes. Depending on the investor’s income and filing status, the rate can be 0, 15, or 20 percent. Most filers will pay 15 percent, but above a certain income threshold, it’s 20 percent.

Three of the most effective methods for avoiding capital gains taxes are 1031 exchanges; offsetting gains with losses; and taking advantage of the primary residence exclusion.

Execute a 1031 exchange

A 1031 exchange gets its name from Section 1031 of the U.S. Internal Revenue Code, which allows an investor to avoid paying capital gains taxes on the sale of an investment property, as long the proceeds are reinvested within certain time limits in a property or properties of equal or greater value.

A 1031 exchange works as a tax-saving mechanism in a variety of ways:

  • It is a swap of properties that are held for business or investment purposes. (Houses that are flipped do not qualify.)
  • For capital gains taxes to be deferred, the properties being exchanged must be considered to be the same type (or “like kind”) in the eyes of the IRS.
  • If used correctly, there is no limit on how many times or how frequently an investor can execute a 1031 exchange.
  • The rules can apply to a former primary residence under very specific conditions.

Offset gains with losses

Also called tax-loss harvesting, offsetting can be used by anyone who has suffered capital losses in a given tax year. The investor can subtract those losses from the capital gains realized from a rental property sale by pairing the gains from the sale with losses from another investment. 

This technique has mostly been seen as a way to offset gains from stock investments, but it is increasingly used to offset gains from real estate profits. 

If an investor makes $100,000 by selling a rental property in Atlanta in the same year as she has an unrealized loss of $125,000 in the stock market, she could opt to sell off a portion of her stocks to realize a $100,000 loss so she can completely offset the $100,000 in capital gains.

Take advantage of the primary residence exclusion

In terms of tax liability, selling a residence is much better than selling a rental property. IRS Section 121 allows taxpayers to exclude up to $250,000 of the profits from the sale of their primary residence if they’re single and up to $500,000 if they’re married filing jointly. 

To qualify, investors must have lived in the property for at least two of the preceding five years. 

To qualify for this, investors could choose to convert a rental property into their primary residence for a period before selling it, or, conversely, live in the property for two years before converting it into a rental. 

However, if the owner has taken deductions for depreciation, she will have to pay taxes on the amount of that depreciation as part of the income, in what is called depreciation recapture. The amount previously taken as a depreciation deduction is taxed at a recapture rate of 25 percent. 

The bottom line on selling an investment property

There are many factors that come into any decision about when to sell an investment property and how to go about it. But there are also numerous ways to minimize the tax implications of the sale. The experts at Mynd can help sellers to execute the sale in the best way possible.

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