Purchasing a rental income property can be a smart move, because it gives you the opportunity to actually create an ongoing source of income on an investment. When you sell that property, though, it’s a bit different than selling your primary residence. Because you used the building as an investment, you’ll need to pay certain federal taxes when you sell.
Understanding Capital Gains Taxes
Federal taxes on long-term investments, also called capital gains taxes, are required when you sell a rental income property. Congress raised capital gains taxes in early 2013, and these taxes are currently set at 20 percent unless your taxable income is low. For instance, if your income is less than $35,350 and you’re not filing jointly, you likely qualify for a zero-percent capital gains tax rate. You’ll pay these taxes for the year in which you sell your investment property. That said, if you sell your rental property within a year of purchasing it, you'll have to pay short-term capital gains taxes, which are assessed at your normal income tax rate.
Calculating Your Basis for Taxes
If you do not qualify for the zero-percent rate, you’ll need to calculate how much you owe in capital gains taxes. First determine the basis of the property. This is the price you originally paid for the rental, plus any improvements you might have made. For example, if you purchased a rental income property for $200,000 and then added a garage or carport for $50,000, your basis would be $250,000.
The Internal Revenue Service allows rental income property owners to deduct property depreciation from their rental income each year. You’ll need to subtract any depreciation you’ve already claimed on the property since you took ownership. Using the above example, if you claimed $60,000 in depreciation since you owned the property, your basis would then be $190,000. Subtract the basis from your sale price and you’ll have the amount of proceeds for which you owe capital gains taxes. Multiply the proceeds by your capital gains tax rate and you’ll know the exact amount of taxes you owe.
Deferring Taxes With a 1031 Exchange
If you’re selling your rental income property to purchase another investment property, you can defer your capital gains taxes with a 1031 tax-deferred exchange. A 1031 exchange lets you apply your sale proceeds directly into a new investment property so you don't decrease your buying power. That said, 1031 exchange transactions have strict rules attached to them, and you must use a qualified intermediary to hold the funds and make sure that all IRS requirements are met. You also must complete the sale of your income property and the purchase of a new one within 180 days.
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