How To Calculate Capital Gains On Sale of a Rental Property?

Understanding how to calculate capital gains when selling a rental property is essential for effective financial planning. The initial step in this computation involves subtracting the property’s adjusted basis at the sale time from the total sales price, including incurred expenses like legal fees and commissions. This calculation yields the capital gain from the sale. To offer clarity on this process, we will delve into a hypothetical scenario in the subsequent sections of our article.

Before delving into the hypothetical illustration, let’s clarify a few key terms:

– The adjusted basis refers to the original purchase price of an asset, plus acquisition expenses and the cost of any capital improvements, minus accumulated depreciation deductions and any deferred capital gains.

– Long-term capital gains denote the profits from selling an asset that has been owned for over a year.

– Depreciation recapture signifies a tax imposed by the IRS when an investor sells investment property to recoup depreciation previously deducted. The depreciation recapture tax amounts to 25 percent of the total depreciation deduction taken for that asset.

To calculate capital gains on the sale of rental property, follow these steps:

  1. Determine your property’s basis. For instance, if you acquired the property for $400,000, this amount serves as the initial basis, unless reduced due to prior 1031 exchanges.
  1. Add acquisition costs, including title expenses, transfer fees, financing costs, realtor commissions, necessary surveys, and legal fees.
  1. Include the cost of substantial property improvements like construction, renovation, landscaping, and enhancements that increase the property’s value.
  1. Deduct factors that reduce the basis, such as depreciation deductions, insurance reimbursements, canceled debts, or payments received for easements.
  1. Subtract the adjusted basis from the selling price. The resulting figure is the capital gain, i.e., the sale price minus the adjusted basis.

Let’s consider an example of calculating capital gains taxes from the sale of a rental property:

Imagine you bought a rental unit four years ago for $400,000, with $20,000 in acquisition costs. The initial basis amounts to $420,000.

You subsequently spent $50,000 on building renovations, raising the adjusted basis to $470,000.

Over the ownership period, you claimed $64,000 in depreciation deductions, decreasing the adjusted basis to $406,000.

Selling the property for $600,000 results in a gain of $194,000. As the holding period exceeds one year, you’ll pay long-term capital gains taxes, which depend on your overall income but typically range from 15 to 20 percent.

Assuming a 20 percent long-term capital gains rate, you’d owe $38,800 on the $194,000 gain. Additionally, you’d owe 25 percent of the depreciation deductions, amounting to $16,000.

Capital gains taxes can substantially impact the net profit from selling an investment property. Investors seeking to manage these taxes might explore deferral options like a 1031 exchange, enabling the reinvestment of the entire sale proceeds.

The provided information is for educational purposes and general information only. It’s based on data from sources deemed reliable, but accuracy isn’t guaranteed, and it shouldn’t be used as the primary basis for investment decisions. This material isn’t a substitute for personalized advice from qualified professionals, especially regarding tax and legal matters. The income stream and depreciation schedule of an investment property can influence tax status and liability. A negative tax ruling could nullify capital gains deferral and lead to immediate tax obligations. Hypothetical examples are purely illustrative.

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