The proceeds from a real estate sale are treated differently depending on the classification of the property. Whether your home is classified as a primary residence, a vacation home, or a rental property, it is crucial to consult with a CPA to anticipate the tax consequences.
Read on for an overview of the taxes involved in the sale of rental property.
Taxes When Selling Rental Property – The Fundamentals
There are two different tax treatments for rental properties, which are “passive activity” and a trade/business property.
Compared to passive income, the losses from rental properties treated as “passive activity” are limited to compensate for other passive income. Depending on the owner’s situation and income limitations applied to the case, it may be possible to deduct up to $25,00 of the losses in the current year.
Any losses not deductible in the current year can be carried forward to the next year. If the owner of a rental property treated as “passive activity” sells the asset while carrying suspended losses related to the rental, he or she is delivered from the losses in the year of the sale.
In such cases, any amount in excess of the gain may be used to compensate for other ordinary income (e.g., wages, investment income, etc.).
If you sell a property with “passive activity” status, the IRS will tax the capital gains from the sale at the long-term capital gain rate. Please note that this rule applies to properties owned for more than one year.
Another interesting aspect is that properties sold at a loss are treated as “ordinary loss,” not capital loss. Hence, the owner can use this loss to compensate for ordinary income, which classifies it as an “IRS Section 1231 loss” or simply a “1231 loss.”
Passive Activity vs. Trade/Business Property
If the rental property is considered a trade or business for tax purposes, the IRS requires the owner to report it as an “IRC Section 1231 gain” or “IRC Section 1231 loss” in case the property is sold.
The federal agency generally applies the long-term capital gain rate to the gains obtained in the sale of this type of property. Conversely, the losses incurred in the sale process can be treated as ordinary losses.
Property sellers considering reporting a “1231 loss” after a real estate transaction must be careful with the recapture provision. In such cases, IRS will track any losses during the process. If the agency recognizes a “1231 gain” through the five years after the “1231 loss,” a portion of these gains may be subject to ordinary income tax.
Rental Property Sales & Depreciation
An often-overlooked aspect of rental property sales is the depreciation of the asset. The gains on a sale of rental real estate are generally subject to up to a 25% tax rate to the extent of the depreciation taken, which is referred to as “depreciation recapture.”
This recapture clause applies both to rental properties treated as “passive activity” or those properties classified as trade or business. If you are selling a rental property in 2023, consult with an expert accountant to identify whether a like-kind exchange can be useful to you
Considering the changes introduced by the Biden administration, the current like-kind exchange proposal would put the annual deferral of gain for up to $50,000 for single taxpayers and up to one million for married filing jointly.
In such cases, any gains made in excess of this fixed threshold would be taxed in the year of the like-kind exchange.
Protect Your Interests When Selling Rental Property – Immediately Consult with an Expert CPA
Whether you are selling a rental property with “passive activity” or trade/business status, the best approach is to rely on professional guidance to preserve your gains. Call Edward D. Quilca, CPA at (786) 310-5582 or email [email protected] to find the best tax strategy for your case.
