For many property owners, it’s not a question of when the sale of rental property should happen. It’s a question of why.
Every property owner will have a different justification behind selling a rental. Some may simply find the upkeep too draining on both their time, energy and patience. Others may be facing what are, quite frankly, untenable situations ranging from judgement liens to outright foreclosure. But there’s one benefit you may not have considered from the sale of rental property: the tax benefit,
Surprised? We don’t blame you. After all, Utah capital gains tax statutes aren’t exactly easy to understand, both at a federal level as well as here in Utah. But learning to understand how it works—and more importantly, how to avoid taking a hit—can help you optimize the sale of your rental property. Let’s look at some of the ways in which selling rental property can cost you; and how to avoid it costing too much.
What Is A Long Term Capital Gain (And Why Is It Subject To Tax?)
A long term capital gain is the profit made from the sale of an investable asset, in this case rental property, which has been held by the seller for over 12 months. Capital gains are legally required to be reported under federal tax law. And the higher both the sale and your household income, the higher your capital gains tax.
Capital gains net tax is only applicable to a secondary property, not your primary residence. And for the most part, it’s rarely going to be higher than 15 percent—unless you’re reporting a household income in excess of $489,000, as indicated by 2023’s capital gains tax rate listed below..
Utah Capital Gains Net Tax For Single Individuals
- HHI (House Hold Income) of $0 to $44,625: 0 percent
- HHI of $44,626 to $492,300: 15 percent
- HHI of $492,301 or more: 20 percent
Utah Capital Gains Net Tax For Married Households
- HHI of $0 to $89,250: 0 percent
- HHI of $89,251 to $553,850: 15 percent
- HHI of $553,851 or more: 20 percent
Still convinced that’s a small price to pay? Let’s take the average cost of a home sale in Utah —reportedly $525,900, according to 2023 estimates, and you paid $350,000 for the house which is its cost basis. Assuming you’re falling into the Utah county median household income of $82,893 reported by the U.S. Census Bureau, that’s roughly $25,431 you’re going to be paying in capital gains tax alone. That doesn’t even include the cost of realtors, necessary repairs or inspection services; all of which are going to seem like virtually pennies in comparison.
That’s the bad news. Here’s some good news: you don’t necessarily have to take that drastic of a hit during the sale of a rental property.
Pros Cons of Selling Rental Property to Pay off Primary Residence
Selling a rental property to pay off a primary residence mortgage can be a good option for homeowners looking to reduce their debt and monthly expenses. However, it’s important to consider the tax implications and other factors before making a decision. Here are some things to keep in mind:
Pros of selling rental property to pay off primary residence:
- Reducing debt: Selling a rental property can provide the funds needed to pay off a primary residence mortgage, which can help homeowners reduce their debt and monthly expenses.
- Increased cash flow: Paying off a primary residence mortgage can increase cash flow and provide more financial flexibility.
- Simplified finances: Owning fewer properties can simplify finances and reduce the time and effort required to manage them.
Cons of selling rental property to pay off primary residence:
- Capital gains tax: Selling a rental property can result in a significant capital gains tax burden, which can eat into profits.
- Loss of rental income: Selling a rental property means losing the rental income it generates, which can impact cash flow and overall financial stability.
- Missed investment opportunity: Real estate can be a good investment, and selling a rental property means missing out on potential future profits.
Options for selling rental property to pay off primary residence:
- Sell and take the tax hit: This is the easiest option, but it may not be the most financially beneficial. Homeowners can sell the rental property, pay any taxes owed, and use the remaining funds to pay off the primary residence mortgage.
- Convert rental property into primary residence: Homeowners can convert their rental property into their primary residence for at least two years before selling it. Doing so allows them to exclude up to $250,000 in capital gains from taxes if they’re single and up to $500,000 if they’re married and filing jointly.
- Refinance rental property: Homeowners can refinance their rental property and use the cash to pay off their primary residence mortgage. This option allows them to keep their rental property and potentially increase cash flow.
Selling a rental property to pay off a primary residence mortgage can be a good option for some homeowners, but it’s important to weigh the pros and cons and consider all available options before making a decision. Consulting with a financial advisor or tax professional can also be helpful in determining the best course of action.
4 Strategies To Minimize Capital Gains Tax When Selling Your Rental Property
1. Tax Loss Harvesting
Tax loss harvesting is a particular strategy which allows you to offset the gains you’ve made on any investment by being paired with an unrealized loss, most commonly in equal or greater value. It’s primarily used by investors to help minimize risks in a volatile stock market, But it’s equally applicable to physical investments as well—particularly to the sale of rental property.
Let’s assume you have approximately $125,000 in a class of mutual funds which are failing considerably. You have an option of holding them in the hopes of a total rebound or selling at approximately $110,000 immediately, leaving you with a net loss of $15,000. That net loss could be applied to the long term capital net gain resulting from the sale of rental property, provided you’ve held both for at least 12 months; effectively reducing your tax rate from $26,000 to $11,000. Is it a total recoup of your tax loss? No; but it can certainly soften the blow!
Note that IRS law states you cannot purchase another asset “substantially identical” to the asset you sold for tax harvesting purposes for at least 30 days; so if you’re looking to make tax loss harvesting a full time strategy, you may want to think twice.
2. Convert Your Rental Property Into Your Primary Residence
Section 121 of the IRS Tax Code allows you to defer up to $250,000 in capital gains tax for single households and $500,000 for couples filing jointly from the sale of a property. There’s just one problem: that property must be your primary residence.
Converting a rental into your primary residence isn’t necessarily difficult. But claiming it for tax deferral purposes could be. It’s a strategy that could prove effective in selling rental property only if:
- You can prove the sale of rental property was actually your primary home.
- You’ve owned that property for at least five years.
- You’ve lived in it for at least two out of those five years.
3. 1031 And Capital Gains of the Sale of Rental Property
Section 1031 (or a “like kind exchange”) is a special tax clause which allows you to acquire one property of equal value in exchange for another and transfer your existing tax basis to that new property. And so long as no substantial profit is made during a section 1031 exchange, it’s considered a capital loss—meaning no actual taxes are due.
However, there’s a limited time frame in a section 1031 exchange..You have 45 days after the sale of a rental property to identify replacement properties; and more specifically, you have up to 180 days to physically close on that property if you hope to defer taxes. And if you can recall when you first bought a home, that time frame isn’t always going to be sufficient
4. Sell The Rental Property As Is
If the value of the rental property has actually depreciated since your initial investment, it’s actually claimable as a tax loss provided the value didn’t actually decrease prior to converting it to a rental.
But how substantially has it decreased? What if it has actually stayed approximately the same? You may be able to claim the sale of a rental property as a loss anyways.
At Gary Buys Houses, we help homeowners find a convenient solution for the dilemmas of capital gains tax rates by purchasing their rental properties as is; sometimes in as little as 3 to 5 business days. What’s more, we can actually give you a fair estimate on the sale of your rental property that in some cases can actually help you profit!
Yes, converting a home into a rental property comes with its own advantages. But when it comes time to the sale of rental property, there’s an entire host of disadvantages. And taxes can be just the tip of the iceberg. But the bottom line is to minimize your risk; and still come out floating on top.
Ware not tax professions. Please contact a tax professional with any questions about the tax implications of selling rental property.