The Internal Revenue Service levies two types of taxes on the sale of a rental house. Sales above your original purchase price plus improvement made on the property are subject to capital gains taxes. The portion of your sale price that is above your depreciated basis but below your original purchase price is subject to depreciation recapture tax. You may, however, be able to defer paying taxes by buying more investment property with the money from the sale.
Calculating Your Gain
Before you can calculate your tax, you need to calculate your gains. To start, you will need to find what the IRS calls your "adjusted cost basis." To calculate your adjusted cost basis, start with your cost basis, which is the purchase price of the property plus any closing costs and adjust it by adding in what you spent on improvements to the property. For example, if you paid $3,000 in closing costs to buy a $125,000 house and put an $8,000 roof on it, your adjusted cost basis woulds be $136,000. You will also need to calculate your sale basis, which is your selling price less any closing costs or commissions. For example, if you sold the house for $200,000 and paid $12,000 in commissions and $5,000 in closing costs, your sale basis would be $183,000. To find your gain, subtract your adjusted cost basis from your sale basis. In this instance, your gain would be $47,000.
Capital Gains Taxes
The IRS charges capital gain taxes on the entire gain when you sell a rental house. If you held the property for less than a year, capital gains get taxed as regular income, so you will pay taxes at your marginal rate. Properties held for more than a year get taxed as long-term capital gains. The tax rate on long-term gains varies depending on your income. For the 2013 tax year, if you make $450,000 or less if you are married, or $400,000 or less if you file as single, long-term gains are federally taxed at 15 percent. If your earnings are above that threshold, the long-term gains rate is 20 percent. In addition to capital gains tax, you will also have to pay a 3.8 percent Medicare surtax on investment income, like capital gains, that is in excess of $200,000 per year if you are single or $250,000 per year if you are married and filing jointly.
The IRS also taxes you for depreciation that you claimed when your property sells for more than its depreciated basis. To calculate its depreciated basis, subtract all of the depreciation that you wrote off while you owned the property from the adjusted cost basis. If you sold for more than your adjusted cost basis, all of the accumulated depreciation is taxable. If you sold for less than your adjusted cost basis, but more that your depreciated basis, the difference between the two would be taxable. In either case, the tax rate on depreciation recapture is 25 percent. Because it's a type of capital gain, it would also be subject to the Medicare recapture tax if you have to pay that, as well.
If you reinvest your proceeds into another piece of rental property, you can set up the transaction as a tax-deferred exchange. When you do this, your new property ends up with the same cost basis as the old property, but you don't have to pay capital gains or recapture taxes. To set your transaction up as a tax-deferred exchange, sometimes called a 1031 exchange or a Starker exchange, the IRS requires you to hire a third party to hold the money between when you sell and when you buy, and to meet stringent timelines. If you're thinking about doing this, your accountant can help you get started.
Steve Lander has been a writer since 1996, with experience in the fields of financial services, real estate and technology. His work has appeared in trade publications such as the "Minnesota Real Estate Journal" and "Minnesota Multi-Housing Association Advocate." Lander holds a Bachelor of Arts in political science from Columbia University.