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How to Calculate Capital Gains on the Sale of Rental Property

When you sell a rental property, you may have to pay capital gains tax. Capital gains are the profit you make when selling something that has increased in value, such as real estate or stock. You can deduct capital losses from your capital gains and vice versa. If you’re a landlord with an investment property, there are ways to reduce your taxes when it comes time to sell it. The first step is knowing what type of property you have and how much it’s worth. After that, check out this article for more information on how to calculate capital gains on the sale of rental property and some helpful tips on lowering your taxes while also remaining completely legal.

 

How to Calculate Capital Gains on the Sale of Rental Property

Capital gains are calculated by subtracting your tax basis from the sale price. Your tax basis is the original cost of the property plus the improvements you made, minus any depreciation that’s been allowed. If the property has been rented out, you must also subtract the rental income you’ve received from your original cost. When calculating capital gains, the only items you can include are the original purchase price, any improvements you’ve made to the property, sales commissions, taxes, and interest paid on a mortgage for the property. Anything else such as repairs, insurance, utilities, and maintenance costs must be deducted from the purchase price when calculating capital gains.

Tax Basis

The tax basis of the property is the price you paid for it plus the amount you spent on improvements. You can include the closing costs, but not other fees such as inspection or appraisal costs. You can also include the amount you paid in set-up fees. However, you can’t include the amount you paid in interest on a mortgage. When you bought the property, you had to pay taxes on that amount. In most cases, the amount of taxes you paid was the same as your tax basis. If you paid more in taxes than your tax basis, then you can claim a deduction on your taxes. If you paid less in taxes than your tax basis, then you have to pay extra in taxes.

 

Recordkeeping for Capital Gains Calculation

You’ll need to have records of your purchase and sale prices, as well as all improvements to the property. Additionally, you’ll need to know the amount of income you’ve received from the rental property if you’re going to subtract it from your purchase price to calculate your tax basis. If you’re keeping all the necessary records, you won’t have to dig through boxes of old paperwork when it comes time to sell the property. All the information you need will be readily available. You can make copies of everything and store them in a safe place. This will make it easier to organize everything and find what you need quickly.

 

The Holding Period Rule

The holding period rule can save you some tax money if you’ve owned a rental property for more than one year. If you’ve owned the property for longer than a year and sell it at a profit, then that profit is considered a long-term capital gain. Long-term capital gains are taxed at a lower rate than short-term capital gains. If you know in advance that you’re going to sell the property at a profit, you can extend the holding period to make the profit long-term capital gains. There are a few ways to do this. You can simply choose not to sell the property for a year. This can be difficult, especially if you’re having trouble finding a buyer. You can also let the property sit unoccupied for a year. You can also take out a “bad tenant” clause in your lease. You can do this by having the lease state that the tenant has to pay for repairs if they damage the property. If the tenant damages the property, simply don’t fix the problem. If the tenant complains, tell them that they have to pay for the repairs themselves. If they don’t, simply just don’t fix the property.

 

Depreciation Recapture Calculation

If you’ve owned the property for less than a year, then any profit you make when you sell it is short-term capital gains. Short-term capital gains are taxed at a higher rate than long-term capital gains. You can lower your profit and taxes by claiming an expense called depreciation recapture. This is essentially the amount of depreciation you’ve taken that you’re now reinstating. To calculate depreciation recapture, you simply take the amount of depreciation you’ve taken and add it to the original cost of the property. Subtract the total from the profit you’ll make from the sale of the property. The difference is your taxes.

 

Exclusion of Gain for Repairs and Improvements

You can lower your taxes by deducting all the repairs and improvements you’ve made to the property. However, you have to keep in mind that you’ll have to pay taxes on the full amount of profit when you sell the property. If you make improvements to the property, you can’t deduct the full amount of the improvement as an expense. You have to remember to subtract the original cost of the property from the cost of the improvement. This will give you the amount you can deduct from your taxes. For example, say you’ve owned a rental property for five years. You’ve made $50,000 worth of repairs to the property. You can deduct the full amount as an expense. However, the property originally cost $100,000. You have to deduct $50,000 from the $50,000 you spent on repairs, which leaves $25,000 that you can deduct from your taxes.

Conclusion

When you sell a rental property, you may have to pay capital gains tax. Capital gains are the profit you make when selling something that has increased in value, such as real estate or stock. You can deduct capital losses from your capital gains and vice versa. When calculating capital gains, you must subtract the original cost of the property, as well as any repairs and improvements you’ve made to the property. You can also extend the holding period of the property by letting the property sit unoccupied or by taking out a “bad tenant” clause in the lease.

 

Check out this youtube video from Bin Chen on avoiding capital gains tax.

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Geisha Morris-Jacobs

Geisha Morris-Jacobs is an accountant with over 13 years of experience in accounting, taxes, and estate planning. She has helped dozens of clients with clearing up IRS audits and past tax debts. Geisha is also the owner of Jacobwise & Co., a boutique accounting firm that specializes in helping small businesses grow their revenue and individuals create estates to provide for their loved ones.

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