In addition to these rates, higher-income taxpayers may also have to pay an extra 3.8% net investment income tax.
Most rental properties are held for over a year. But if you sell real estate at a profit after owning it for one year or less, the profit is a short-term capital gain. So it's taxable as ordinary income at your marginal tax rate.
Depreciation recapture tax
The depreciation "expense" that you’re entitled to each year can save you tons of money when it comes to taxes.
The drawback is that the IRS wants its money when you sell the property. Like many other investment-related tax benefits, you can’t get out of paying taxes forever.
Think of it like a traditional IRA. Investors can deduct their IRA contributions on their tax returns in the year they’re made. That way they don’t have to pay annual taxes on dividends or capital gains. But when they withdraw money, it's taxable income. The same concept applies here. It's called depreciation recapture tax.
Depreciation initially reduced your taxable rental income, which is taxed as ordinary income. Because of that, depreciation recapture is also taxed at ordinary income tax rates (as opposed to favorable long-term capital gains rates).
I’ll go through an example in the next section. The key point is that if you held a rental property for 10 years and used a $5,000 depreciation expense each year, you'll owe depreciation recapture tax on $50,000 when you sell.
If you didn’t claim depreciation on a rental property, you’ll still get hit with depreciation recapture tax. The IRS calculates depreciation recapture based on "allowed or allowable" depreciation. So you can’t get out of this by not claiming depreciation expenses.
An example of the sale of a rental property
Let’s look at a simplified example of how this might work in the real world.
Let’s say you spend $250,000 to acquire a rental property. According to the property’s assessment, the land is worth $50,000 and the building is worth $200,000. This gives you a depreciation expense of $7,273 per year. We’ll say that you’re in the 24% marginal tax bracket for ordinary income and the 15% bracket for long-term capital gains.
You hold the property for six years and sell it for $280,000, so you have a $30,000 long-term capital gain on the sale. Based on your 15% capital gains tax rate, you owe capital gains tax of $4,500.
In addition, you've been allowed a total depreciation expense of $43,636 over your six-year holding period. You’ll pay a 24% tax rate on this amount for a total depreciation recapture tax of $10,473.
Adding your depreciation recapture tax to your capital gains tax shows a total tax bill of $14,973 on the sale of the property.
A 1031 exchange can help you avoid taxes when you sell
That sounds like a huge tax bill. But there's good news for investors: you can avoid paying capital gains and depreciation recapture taxes when you sell a rental property. You just need to use a 1031 exchange.
I won’t get into too much detail here -- we have a guide to 1031 exchanges that contains everything you need to know. The general idea is that if you sell an investment property, you won't pay any taxes on the sale if you use the proceeds to buy a similar property.
You have to buy the new property for the same amount as or more than what you sold the first property for. And it needs a similar financing structure.
If you sell an investment property for $300,000 with a $150,000 mortgage remaining, your new property must cost at least $300,000 and have financing of the same amount or more.
And you need to identify properties within 45 calendar days of the sale of the first property. You have to close on the new property within 180 days, too.
There are other rules for completing a 1031 exchange, so be sure to do your research before starting the process.
Defer to a professional if you’re not sure
I’ve covered most of the tax concepts rental property owners need to know, but not every situation is black-and-white. Like with most other tax concepts, there are gray areas.
For example, you might not be sure if a certain expense is deductible. Or you may not know how to value the land your rental property is built on for depreciation. Maybe you aren’t sure if you can claim the QBI deduction or for how much.
There’s no way to cover every possible tax situation you might run into as a rental property owner. If you come across a rental property tax issue and you aren’t sure what to do, consult a professional. A tax attorney or a reputable and experienced tax preparer can answer your questions.