Selling Your Rental Property

By Jason Watson, CPA
Posted Monday, August 5 2024

This section is not about how to precisely calculate your tax on a property sale. Rather, we discuss some considerations to resolve as you go through the process of selling your rental property.

Cost Basis Audit

The first thing we recommend when selling any property, especially a rental property which might not enjoy a capital gains exclusion, is a cost basis audit. What do we mean here?

When WCG CPAs & Advisors gleefully accepts a new client, there is some level of trust in the prior tax professional’s work. For example, we obtain a fixed asset listing with associated depreciation schedules, and we see a rental property asset with a $400,000 building unadjusted cost basis and another $100,000 asset allocated to land. Cool.

Were acquisition costs missed such as title fees and travel expenses associated with the purchase? Did the rental property owner install a new deck, but never told anyone? Is this $500,000 ($400,000 + $100,000) correct, or did something break within the tax returns along the way?

Therefore, we encourage a cost basis audit. This is a detailed review of the original purchase price, plus acquisition costs and improvements. You need to be careful not to include items you immediately expensed under a safe harbor. This would be a double-dip, right? You had a tax benefit when expensed and another when you increased your cost basis (which lowers your gain). Sorry, Charlie.

Depreciation Recapture

As we defined in our glossary- If you sell or otherwise dispose of depreciated business property including real estate property for a gain (the sale price exceeds the adjusted cost basis), depreciation recapture permits the IRS to take back (i.e., “recapture”) some of the tax benefits you received over the years through depreciation deductions. As such, depreciation might be a little tax bomb or IOU to the IRS.

The play on depreciation with assets which don’t normally depreciate, such as real estate, is to take the cash savings from reduced taxes and redeploy them into other investments. This is nearly identical to any pre-tax IRA or 401k contribution. The IRS will be asking for you to pay taxes in the future; until then, you enjoy more spendable cash “on loan” from the IRS.

Please recall our discussions on Section 1245 and 1250 property. Quickly, Section 1245 is personal property and is usually identified with a cost segregation study. Section 1250 property is the remaining building. Why is this important?

Depreciation recapture is taxed as ordinary income (not long-term capital gains). However, Section 1250 property has a maximum depreciation recapture tax rate of 25%. As such, if you are in the 37% marginal tax bracket, you only pay a 25% tax rate. Some tax arbitrage exists if you were able to deduct the depreciation at 37% and pay it back, if you will, at 25%.

Keep in mind that Section 1245 property and the associated depreciation recapture does not enjoy this 25% limit. First, bummer. Second, this can be a large surprise- imagine $50,000 in Section 1245 property at 37% marginal tax rate. This would be a $18,500 tax bill.

Land Arbitrage

This is a little obscure, but important just the same. When you sell a rental property, intrinsic to the deal is the conveyance of the land and the building. Yes, they are combined usually, but from a tax return perspective, these are different assets.

How does this affect you? What if the land increases more than the overall gain in property value? In other words, the market is rewarding geographic location more than the building itself (and the area could be heading towards the preference to buy, scrape and build new).

Consider-

Original Purchase Price (cost basis)	500,000
Building	400,000
Land	100,000
Depreciation Taken (a)	75,000
Building Adjusted Cost Basis (b)	325,000
Selling Price	650,000
Appraisal’s Fair Market Value of Land	300,000
Remainder to be Applied to Building (c)	350,000
Building Adjusted Cost Basis (b)	325,000
Depreciation Recapture (c – b)	25,000
Depreciation Taken (a)	75,000
Tax Arbitrage	50,000

This table shows a reduction in depreciation recapture. How? The value of the property, as a whole, increased from $500,000 to $650,000. However, according to the appraisal at the time of sale, the land increased from $100,000 to $300,000. Where did this $100,000 come from? Either the county assessment of the property or an original appraisal (let’s assume it is correct or fair for sake of argument).

As such, when applying the purchase price to land first and building second, the amount applied to the building is $50,000 less than the unadjusted cost basis originally allocated to the building. In turn, the amount of depreciation recapture is reduced from $75,000 to $25,000.

This is an often-overlooked tax planning tool that even the most seasoned tax professionals and real estate CPAs miss. Real estate scenarios where the land value increases year over year as a ratio to the overall value of the property are very common- take any lakefront property in a nice area and do some historical review of the county assessment including new building permits for scrapes (tear down and rebuild). It will be enlightening.

Passive Activity Losses Upon Disposition

The IRS sums this up nicely in Topic No. 425, Passive Activities – Losses and Credits by stating, “Generally, you may fully deduct any previously disallowed passive activity loss in the year you dispose of your entire interest in the activity.”

Form 8582 which accompanies your individual tax return (Form 1040) tracks unallowed passive activity losses for each activity. If you have three rental properties which have losses, and assuming they are all long-term rentals and you don’t qualify with real estate professional status (REPS), each property would be listed on Form 8582 as a separate activity.

Sidebar: Passive losses from certain K-1’s are also tracked using Form 8582 so that when you either have passive income or you dispose of the K-1 (redeem, sell, get out of the investment, etc.), these previously unallowed losses are accounted for.

The IRS in their topic above uses the word disallowed. Form 8582 uses the word unallowed. Schedule E Part II uses the word unallowed. These can be viewed as the same, but unallowed is preferred unless you are playing scrabble then disallowed is fair game. According to Cornell Law, “Disallowance means a denial. In the context of taxes, disallowance is a finding by the IRS after an audit that a business or individual taxpayer was not entitled to a deduction or other tax benefit claimed on a tax return.”

We digress. Other tidbits-

• The “release” of unallowed losses upon the sale of your rental property can certainly assist in your depreciation recapture and subsequent tax bill problem.

• When changing tax professionals, please ensure Form 8582 is discussed. If you break the chain between tax years, you might be hosed.

Rental Was Your Primary Home

As most real estate investors know, there is a $250,000 exclusion for single taxpayers and $500,000 exclusion for married taxpayers on the gains attributed to the sale of a primary residence. According to IRC Section 121, there are two tests-

• Owned the home for at least two years (the ownership test), and
• Lived in the home as your main home for at two years of the past five years (the use test)

The ownership and use test do not have to overlap (you could rent a home for two years, purchase it, convert to a rental, and sell two years later and still be eligible for the gain exclusion). Additionally, the two years do not have to be consecutive. The best way to compute or think about this is to consider months as your unit of measurement- 24 out of 60. This helps with fragmented ownership and use periods.

There are several exceptions for health, work-related move, unforeseen circumstances, death, divorce, government personnel on extended duty (think military) among others. We will not go into these, however, since IRS Publication 523 Selling Your Home has nauseating details and examples.

When we have a mixed-use situation, you must consider the period of non-qualified use which might limit how much of the gain is excluded. According to IRC Section 121(b)(5)(C)–

The term “period of nonqualified use” means any period (other than the portion of any period preceding January 1, 2009) during which the property is not used as the principal residence of the taxpayer or the taxpayer’s spouse or former spouse.

There are two basic scenarios with varying outcomes when you sell a property that was both a rental and your primary residence-

• The property was a rental first, and then you occupied the property as your primary residence.

• The property was your primary residence first, and then you converted it into a rental.

The immediate perspective on these scenarios is that you can influence the tax effects by the time spent living in the property as your primary residence. In other words, delaying a sale to increase the time spent as a primary residence might prove beneficial.

Let’s run through these two examples-

The first example involves some math since a portion of the gain is not excludable because of nonqualified use. This is because the property was not used a primary residence for a portion of the entire ownership period. This contrasts with the thought that the amount of exclusion is reduced. Huh?

In other words, the tax code when written could have either reduced the amount of the exclusion or it could have limited the amount of gain eligible for exclusion. Again, subtle difference. The good news is that as written, IRC Section 121 limits the amount of gain eligible for exclusion which is a loophole of sorts or perhaps a version of tax arbitrage.

Consider-

Gain on Property Sale (a)	650,000
Years of Non-Qualified Use	3
Years of Total Ownership	12
Percentage (b)	25%
Non-Excludable Gain (a x b)	162,500
Excluded Gain under IRC Section 121	487,500

The above example is how the law works assuming married taxpayers. But what if the exclusion amount of $500,000 was reduced by the period of non-qualified use? You would have this-

IRC Section 121 Gain Exclusion	500,000
Gain Exclusion Reduction (fictitious)	125,000
Adjusted Gain Exclusion (fictitious)	375,000
Illustrative Difference	112,500

In our fictitious second example, $112,500 would not be excluded because the exclusion amount was reduced (versus reducing the amount of gain that is eligible for exclusion). Our apologies for belaboring this point.

Neat. Let’s move on to the second scenario where the property was your primary residence first, and then you converted it into a rental. IRC Section 121(b)(5)(C)(ii)(I), yeah deep deep deep into the code, reads-

(ii) Exceptions. The term “period of nonqualified use” does not include-

(I) any portion of the 5-year period described in subsection (a) which is after the last date that such property is used as the principal residence of the taxpayer or the taxpayer’s spouse,

What does this mean? If you owned a property for five years, and for the first three years it was your primary residence, the period afterwards is not included as a “period of nonqualified use.” Therefore, you would enjoy the full gain exclusions of $250,000 (single) or $500,000 (married).

But not so fast! What about depreciation recapture? Depreciation recapture is not excludable. Ah, we just buzz-killed the topic, didn’t we?

Here is an example of a mixed-use property (rental and primary residence) where the eligible gain is reduced plus depreciation recapture-

Original Purchase Price (cost basis)	500,000
Depreciation Taken	75,000
Adjusted Cost Basis (a)	425,000
Sale Price (b)	675,000
Preliminary Gain (b – a)	250,000
Depreciation Recapture	75,000
Remaining Gain to Be Considered (c)	175,000
Years of Non-Qualified Use	3
Years of Total Ownership	12
Percentage (d)	25%
Non-Excludable Gain (c x d)	43,750
Excluded Gain under IRC Section 121	131,250

In this example, the property owner will pay-

• Ordinary taxes (up to 25% assuming all Section 1250 property) on the depreciation recapture of $75,000, and

• Long-term capital gains taxes on the $43,750.

The big takeaway is the ability to influence some of the math with how much time is spent using the property as your primary residence. Tax planning is a must.

1031 Like-Kind Exchange

We would be remiss in our discussions about selling your rental property if we didn’t mention a 1031 like-kind exchange including the IRC Section 721 exchange cousin. We dig deep into this in our 1031 lime-kind exchange section.