Taxation on Sale of Rental Properties

Can Investors Avoid Capital Gains Taxes?

Long-time real estate investors may find that they have significant equity tied up in rental properties. As life progresses, they may want to use this equity to fund other life needs and interests — investments in additional real estate, angel investing, retirement funding, extended vacations, college funding for grandkids, etc. However, the concern is that selling rental properties can result in a huge capital gains tax, unless a 1031 exchange is implemented. What can be done?

If you are a higher income investor, you may be in for a pleasant surprise. If you’ve been at a higher income level during the period of owning rental properties, and incurred income losses, you may not have been able to deduct those losses on your taxes. Under the passive activity rules, if your modified adjusted gross income (MAGI) is over $150,000, then you cannot deduct passive losses.

So, when your rental property is sold, all of those pent-up losses on rentals can be “released” — and taken all at once, effectively acting as a potentially substantial reduction in capital gains tax! Further, these losses are released at ordinary income tax rates, which are typically higher than capital gains for high income investors — a double benefit. This applies to any class of rental property.

Of course, you’ll want to confirm your potential taxation before listing your rental properties for sale. See your CPA, who can do an analysis to help determine total taxation (including investment surcharge) and net proceeds.

NIIT Surtax of 3.8%

Many investors are surprised to find out that selling their rental property investment can result in an extra 3.8% surtax, in addition to the applicable short-term or long-term capital gains tax rates. This is the Net Investment Income Tax (NIIT; also known as the Medicare tax because of its allocation per Section 1411 of the IRS code on investment income). The surtax is charged on the lesser of (1) net investment income or (2) the excess of modified adjusted gross income over a set threshold amount ($250,000 for joint filers, $125,000 for married filing separately, and $200,000 for all other filers). Investors can potentially minimize or avoid this surtax by planning methods that reduce their MAGI below the threshold.

Get that Tax Analysis Done First!

Since the residential real estate inventory is currently low, is this a good time to sell for investors? A key factor is taxation. MyCFO can help to determine your tax exposure. Contact us today!