A couple of weeks ago I wrote a blog about how a primary residence gets taxed when sold. Continuing down that path, in today's post I wanted to discuss how residential rental properties are taxed.
Let’s talk through a hypothetical scenario to discuss the two main ways rentals get taxed:
Income tax on the rental income earned each year
Capital Gains taxes on sale
Phase 1: Renting the house
Bill buys a $200,000 house to rent out. In the first year he collects $18,000 in rent.
He doesn’t have to claim all $18,000 as income, he gets to deduct rental expenses against this income before getting the taxable amount.
His expenses for the first year were:
Maintenance & repairs $2,000
Property taxes $2,000
Mortgage interest $3,000
Depreciation* (more on this below): $7,272
Total expenses in year one: $14,272
Profit was $3,278 ($18,000 - $14,272). Bill has to claim and pay tax on this amount.
Rental income gets taxed as ordinary income, so if Bill is in the 22% tax bracket he would pay $721 in tax. (3728 x 22%).
Ordinary income brackets:
*Depreciation: a property can’t be rented out forever, it has a ‘useful life’. The IRS says that residential real estate has a 27.5 year useful life, so you get to take an equal depreciation expense every year for 27.5 years. ($200,000/27.5 = $7,272)
Remember, you don’t actually pay depreciation. It’s an intangible expense that helps reduce your tax bill on the rental income each year.
On the surface the tax on rental income is pretty simple, but you can get really complex when you talk about expenses like mortgage points, repairs vs improvements, car mileage, etc. Have an experienced CPA or bookkeeper help you keep up with this.
Phase 2: Selling the rental house
Bill sells the house for $250,000 in year 5. What is his gain?
Since this is not his primary residence he doesn’t get the $250,000 gain exemption that I’ve written about in the past. That exemption is only on a primary residence.
Taxable Gain = $250,000 - adjusted cost basis
What is adjusted cost basis? The price you paid for the house + any improvements you’ve made (not repairs but improvements) - depreciation expense taken.
Let’s say Bill didn’t make any improvements. We’d calculate his gain as:
$250,000 - $163,640 = $86,360 of taxable gain
Where did $163,640 come from? $200,000 purchase price - $36,360 depreciation (5 years * $7,272)
Bill has to pay capital gains tax on $86,360. His cap gains rate is 15% due to his income, and because he held the property more than one year.
Bill owes $12,594 in capital gains tax (15% * $86,360).
Capital gains brackets:
But wait…there’s more! The 1031 exchange. This is a very important tool every property investor should know.
A 1031 exchange is when you reinvest the proceeds into a like-kind property within an allotted time frame. This allows you to defer the capital gains tax payment until the sale of this next property. There is no limit to how many 1031 exchanges you can do. So in theory you could continue to exchange properties growing your gain, and push the tax bill down the road (hopefully when you’re in a lower tax bracket).
This doesn’t mean you avoid the capital gains entirely but it pushes the tax bill down the road until you sell the exchanged property.
Selling property can be complex. Having knowledge of taxes and tools to help you mitigate those taxes can pay off big time!