How to calculate gain on sale of rental property

When you sell a rental property, your profits are subject to capital gains tax since you don't get the same exclusions that you do on your personal residence. However, given that the Internal Revenue Service lets you use what you pay for closing costs and for property improvements to both reduce your selling price and increase your purchase cost, your profit might not be as large as you think. On the other hand, depreciation recapture might leave you with an additional unexpected tax bill.

Tips

• The amount of capital gains you will pay on the sale of your rental property will largely be determined by the length of time you owned it and the specific tax bracket you find yourself in following the sale.

Adjusted Cost Basis

To find the cost of the home, start with your original purchase price. You can add most of the closing costs that you paid when you bought it, although you'll have to leave your mortgage-related costs out. For instance, if you bought your rental for $95,000, paid $1,200 in title costs, $750 in legal fees, and $1,800 for your mortgage, your cost would be $96,950, which encompasses everything but the mortgage.

Next, add in the cost of any improvements that you made to the house. An improvement is anything that you do to the property that increases its value, changes its use or makes it last longer, and includes everything from adding a swimming pool to replacing a roof to renovating a bathroom. If you spent $9,000 on a new roof and $10,500 on a kitchen remodel, you'd add that $19,500 to the $96,950 cost to find a total adjusted basis of $116,450.

Assessing the Amount Realized

Your gain doesn't come from subtracting your selling price from your total cost. The IRS lets you pull all of your sale-related expenses out of the price first to calculate what it calls the amount realized. For instance, if you sold the house for $179,000, paid a 6.5 percent commission of $11,635 and paid $3,250 in closing costs, your amount realized would be $164,115.

Calculating Gain or Loss

To find your gain or loss, subtract your adjusted basis from your amount realized. If the number is positive, you have a gain that will be taxable. If it's negative, you have a loss that you can use to offset other taxable gains. To find the bottom line for a house with a $116,450 adjusted basis and a $164,115 amount realized, subtract the former from the latter to find a total gain of $47,665. The tax treatment of the gain depends on how long you held the asset – short-term capital gains taxes apply to homes held for less than one year, and long-term gains apply if you hold it for more than a year.

Capital Gains Tax

Assuming that you held the house for over a year and made a profit, your capital gains tax rate depends on your income. If your income falls in the lowest two tax brackets, your capital gains rate is zero percent. When you start paying taxes in the third bracket, the capital gains tax rate goes up to 15 percent. If you're in the top tax brackets, you'll pay a 20 percent capital gains rate.

If your income is $200,000 or higher if you're single or $250,000 or higher if you're married, you'll have to pay a 3.8 percent Net Investment Income Tax (NIIT) surcharge. If you held the house for less than a year, your tax rate will be your regular income tax rate, plus the 3.8 percent surcharge if your income is high enough. These rates change on an ongoing basis, but were current as of late 2019.

Depreciation and Recapture

Even if you have a loss, you might still have to pay tax. The IRS has one more surprise for rental property owners. While you owned your rental property, you were entitled to depreciate the building and any improvements. If you sell it for more than the value after subtracting all of your depreciation, you'll have to pay a special 25 percent Section 1250 depreciation recapture tax on the depreciation you claimed.

For example, when you have a property with a $125,000 adjusted basis and you've claimed $55,000 in depreciation, the depreciated basis is equal to $70,000. You pay the 25 percent recapture tax on the difference between the depreciated basis and the sales price, up to $125,000. If you sell for more than that price, it's a capital gain and subject to the capital gains tax rate.

Capital Gains

If you are reading about capital gains, it probably means your investments have performed well. Or you're preparing for when they do in the future.

If you’ve built a low-cost, diversified portfolio and the assets you hold are now worth more than what you paid for them, you might be thinking about selling some assets to realize those capital gains. That's the good news.

The not-so-good news is that your gains are subject to taxation at the federal and state level. Let's talk about capital gains taxes - what they are, how they work and why, exactly, you should care about them.

A financial advisor can help you manage your investment portfolio. To find a financial advisor who serves your area, try our free online matching tool.

Capital Gains: The Basics

Let's say you buy some stock for a low price and after a certain period of time the value of that stock has risen substantially. You decide you want to sell your stock and capitalize on the increase in value.

The profit you make when you sell your stock (and other similar assets, like real estate) is equal to your capital gain on the sale. The IRS taxes capital gains at the federal level and some states also tax capital gains at the state level. The tax rate you pay on your capital gains depends in part on how long you hold the asset before selling.

There are short-term capital gains and long-term capital gains and each is taxed at different rates. Short-term capital gains are gains you make from selling assets that you hold for one year or less. They're taxed like regular income. That means you pay the same tax rates you pay on federal income tax. Long-term capital gains are gains on assets you hold for more than one year. They're taxed at lower rates than short-term capital gains.

Depending on your regular income tax bracket, your tax rate for long-term capital gains could be as low as 0%. Even taxpayers in the top income tax bracket pay long-term capital gains rates that are nearly half of their income tax rates. That's why some very rich Americans don't pay as much in taxes as you might expect.

To recap: The amount you pay in federal capital gains taxes is based on the size of your gains, your federal income tax bracket and how long you have held on to the asset in question.

To figure out the size of your capital gains, you need to know your basis. Basis is the amount you paid for an asset. How much you owe in taxes - your tax liability - stems from the difference between the sale price of your asset and the basis you have in that asset. In plain English, that means you pay tax based on your profit.

Earned vs. Unearned Income

Why the difference between the regular income tax and the tax on long-term capital gains at the federal level? It comes down to the difference between earned and unearned income. In the eyes of the IRS, these two forms of income are different and deserve different tax treatment.

Earned income is what you make from your job. Whether you own your own business or work part-time at the coffee shop down the street, the money you make is earned income.

Unearned income comes from interest, dividends and capital gains. It's money that you make from other money. Even if you're actively day trading on your laptop, the income you make from your investments is considered passive. So in this case, "unearned" doesn't mean you don't deserve that money. It simply denotes that you earned it in a different way than through a typical salary.

The question of how to tax unearned income has become a political issue. Some say it should be taxed at a rate higher than the earned income tax rate, because it is money that people make without working, not from the sweat of their brow. Others think the rate should be even lower than it is, so as to encourage the investment that helps drive the economy.

Tax-Loss Harvesting

No one likes to face a giant tax bill come April. Of the many (legal) ways to lower your tax liability, tax-loss harvesting is among the more common - and the more complicated.

Tax-loss harvesting is a way to avoid paying capital gains taxes. It relies on the fact that money you lose on an investment can offset your capital gains on other investments. By selling unprofitable investments, you can offset the capital gains that you realized from selling the profitable ones. You can write off those losses when you sell the depreciated asset, canceling out some or all of your capital gains on appreciated assets. You can even wait and re-purchase the assets you sold at a loss if you want them back, but you'll still get a tax write-off if you time it right. Some robo-advisor firms have found ways to automate this process by frequently selling investments at a loss and then immediately buying a very similar asset. This allows you to stay invested in the market while still taking advantage of the tax deductions from your losses.

Some people are devotees of the tax-loss harvesting strategy. They say it saves you big bucks. Others say that it costs you more in the long run because you're selling assets that could appreciate in the future for a short-term tax break. You're basing your investing strategy not on long-term considerations and diversification but on a short-term tax cut. And if you re-purchase the stock, you're essentially deferring your capital gains taxation to a later year. Critics of tax-loss harvesting also say that, since there's no way of knowing what changes Congress will make to the tax code, you run the risk of paying high taxes when you sell your assets later.

State Taxes on Capital Gains

Some states also levy taxes on capital gains. Most states tax capital gains according to the same tax rates they use for regular income. So, if you're lucky enough to live somewhere with no state income tax, you won't have to worry about capital gains taxes at the state level.

New Hampshire doesn't tax income, but does tax dividends and interest. The usual high-income tax suspects (California, New York, Oregon, Minnesota, New Jersey and Vermont) have high taxes on capital gains, too. A good capital gains calculator, like ours, takes both federal and state taxation into account.

Capital Gains Taxes on Property

If you own a home, you may be wondering how the government taxes profits from home sales. As with other assets such as stocks, capital gains on a home are equal to the difference between the sale price and the seller's basis.

Your basis in your home is what you paid for it, plus closing costs and non-decorative investments you made in the property, like a new roof. You can also add sales expenses like real estate agent fees to your basis. Subtract that from the sale price and you get the capital gains. When you sell your primary residence, $250,000 of capital gains (or $500,000 for a couple) are exempted from capital gains taxation. This is generally true only if you have owned and used your home as your main residence for at least two out of the five years prior to the sale.

If you inherit a home, you don't get the $250,000 exemption unless you've owned the house for at least two years as your primary residence. But you can still get a break if you don't meet that criteria. When you inherit a home you get a "step up in basis."

Say your mother's basis in the family home was $200,000. Today the market value of the home is $300,000. If your mom passes on the home to you, you'll automatically get a stepped-up basis equal to the market value of $300,000. If you sell the home for that amount then you don't have to pay capital gains taxes. If you later sell the home for $350,000 you only pay capital gains taxes on the $50,000 difference between the sale price and your stepped-up basis. If you’ve owned it for more than two years and used it as your primary residence, you wouldn’t pay any capital gains taxes.

Nice, right? Stepped-up basis is somewhat controversial and might not be around forever. As always, the more valuable your family's estate, the more it pays to consult a professional tax adviser who can work with you on minimizing taxes if that's your goal.

Net Investment Income Tax (NIIT)

Under certain circumstances, the net investment income tax, or NIIT, can affect income you receive from your investments. While it mostly applies to individuals, this tax can also be levied on the income of estates and trusts. The NIIT is levied on the lesser of your net investment income and the amount by which your modified adjusted gross income (MAGI) is higher than the NIIT thresholds set by the IRS. These thresholds are based on your tax filing status, and they go as follows:

• Single: $200,000
• Married filing jointly: $250,000
• Married filing separately: $125,000
• Qualifying widow(er) with dependent child: $250,000
• Head of household: $200,000

The NIIT tax rate is 3.8%. The tax only applies for U.S. citizens and resident aliens, so nonresident aliens are not required to pay it. According to the IRS, net investment income includes interest, dividends, capital gains, rental income, royalty income, non-qualified annuities, income from businesses that are involved in the trading of financial instruments or commodities and income from businesses that are passive to the taxpayer.

Here's an example of how the NIIT works: Let's say you file your taxes jointly with your spouse and together you have $200,000 in wages. The threshold for your filing status is $250,000, which means you don't owe the NIIT solely based on that income. However, you also have $75,000 in net investment income from capital gains, rental income and dividends, which pushes your total income to $275,000. Because your income is now $25,000 past the threshold, and that number is the lesser of $75,000 (your total net investment income), then you would owe taxes on that $25,000. At a 3.8% tax rate, you'd have to pay $950.

Bottom Line

At SmartAsset we're all about investing in your future. If your investments perform well and you want to sell, you'll have higher tax bills to match. It's up to you to decide the lengths you want to go to in the quest to trim your capital gains tax liability. If you decide to go with a "buy and hold" strategy you won't have to think too much about capital gains until you decide to liquidate your investments.