When selling your rental property in the military, your decision can be based on any number of reasons:
- Leaving active duty
- Buying a bigger home
- Because it makes financial sense to do so.
In fact, I previously wrote an article about selling your home in the military. However, there are times in your military career where you just can’t sell your home as soon as you leave it:
- You’re underwater
- You might move back into it later on
- It’s got potential to make a lot of money as a rental
- Timing issues.
From the moment you have a tenant move into your house, it’s no longer your home… it’s a rental property. Whatever the reason for selling your rental property, there are three important tax considerations. If you don’t account for them, you might miscalculate your tax liability. Miscalculating your tax liability when selling your rental property will ensure you either pay too much in taxes or risk running afoul of the IRS.
Let’s look at these three tax considerations when selling your rental property.
Selling Your Rental Property Consideration #1: Your realized gain
When selling your rental property, you need to consider realized gain. The IRS definition of realized gain takes into account a lot of things you may not have considered. According to the IRS, the basic formula for calculating your realized gain is:
Selling price – Selling expenses – Adjusted basis
This means you need to calculate two things: selling expenses & basis. Proper calculation of selling expenses & basis could mean a difference of thousands of dollars in tax liability.
Selling expenses include any seller’s closing costs, real estate commissions, and any other related selling costs. You should comb through your closing documents to make sure you’ve properly accounted for all selling expenses. Do not include city & county property tax, but do include transfer taxes, if applicable.
Basis includes the original purchase price of your house, plus fees incurred during home closing, such as title insurance, legal & recording fees, or survey fees. Basis also includes the cost of any major improvements, renovations, or system replacements. The IRS makes a clear distinction between repairs and improvements. Repairs are a normal part of keeping a home in good condition (such as repairing leaks). Improvements, such as replacing the plumbing system, are complete replacements or capital expenditures.
Below are two breakdown of my personal example. I sold a home last year, which had been a rental for the previous 8 years. Since I couldn’t put the actual numbers into the charts, they’re summarized below:
- Purchase price: $160,000
- Closing costs: $3,000
- Improvements: $10,000
- Commissions: $10,500
- Depreciation: $6,000
- Sales Price: $210,000
Below, Example 1 shows the home’s adjusted basis (in blue) and adjustments in sales price. This includes closing costs, fees, and improvements. The taxable items, recaptured depreciation & profit (addressed separately below), are in red. Example 2 shows the home’s basis without these adjustments.
Example 1: Selling My Rental Property (with adjustments)
Example 2: Selling My Rental Property (without adjustments)
So what’s the point?
As you can see, the adjustments account for over 10% of the selling price of the home ($23,500), which can affect your tax liability. If you properly adjust your basis (as shown in Example 1), you can legally avoid paying taxes on those items. However, many people forget this, and their tax situation looks a lot like Example 2, which in this case would mean recognizing an additional $23,500 in income. When selling your rental property, you want to look like Example 1. Avoid looking like Example 2. Take the time to figure out your costs and save that money.
For a more comprehensive list of what can & cannot be included in selling expenses or basis calculation, you can refer to the IRS Publication 523, ‘Selling Your Home,’ which is user-friendly and available online.
Selling Your Rental Property Consideration #2: Section 121 Tax Exclusion
Under Section 121, the IRS allows a taxpayer to exclude the first $250,000 of capital gain ($500,000 for married couples filing jointly) on the sale of their primary residence if they meet certain ownership and use requirements. When selling your rental property, you can still use Section 121 tax exclusion, if you otherwise meet the requirements:
- Ownership requirement: You owned the home for at least 24 months of the 5 years leading up to the sale
- Use requirement: If the home was your primary residence for at least 730 days of the previous 5 years
- If you’re married filing jointly, you must each meet the use requirement, even if only one person meets the ownership requirement to qualify for the $500,000 exclusion.
- If you’re not married, but selling the house with someone else, you may each take the $250,000 exclusion as long as each of you meets the use requirement, and at least one of you meets the ownership requirement.
Learn more about Section 121 tax exclusion in this video!
Even if you do not meet the requirements for a full exclusion, the IRS allows partial exclusions if you sell the home due to work or health related moves, or due to unforeseeable events such as death, divorce, natural disaster, unemployment, or other qualifying reasons. IRS Publication 523 contains more details.
In the military, there is a special exception that allows you to defer the 5 year requirement for up to 10 years (known as ‘stop the clock’ exception), if you are on qualified extended duty. Qualified extended duty includes the following:
- Being called or ordered to active duty for an indefinite period, or a definite period of more than 90 days
- Serving at a duty station at least 50 miles from your main home, or you are living in Government quarters under Government orders.
- Membership in the armed forces (Army, Navy, Air Force, Marine Corps, Coast Guard)
Using the Stop the Clock exceptions means that you would be able to combine the 5-year test period and the 10-year suspension period for a total of up to 15 years. When selling your rental property, you’re also able to use the Stop the Clock exception, as long as you meet the requirements. You can only suspend the 5-year period for one property at a time, so keep this in mind if you have multiple properties.
You will pay capital gains on any income above and beyond the Section 121 exclusion. However, if you hold onto this property for more than 1 year, you will pay income tax at long-term capital gains rates. Long-term capital gains rates are much more favorable than ordinary income rates.
Selling Your Rental Property Consideration #3: Depreciation
The last discussion item, and probably the most important one, is depreciation. From the time you convert your home to a rental property, you are eligible to depreciate this property (not land, building & improvements only) over its useful life. The IRS considers the useful life for residential real estate put into service after 1986 to be 27 ½ years, which you would depreciate on a straight-line basis. This means you can take an equal amount of depreciation each year until your basis goes to zero. This depreciation is eligible as a tax deduction on Schedule E of your tax return.
Conversely, when you go to sell your rental property, you must ‘recapture’ this depreciation. This is known as Section 1250 depreciation recapture. Assuming you depreciated the property on a straight-line basis, Section 1250 recaptured depreciation is taxed at a flat 25% capital gains rate. Any accelerated depreciation may be taxed at your ordinary income tax rate.
Why point this out? If you’ve had tenants in your rental property for a while, you may end up with a big tax bill when you sell. The IRS will probably calculate your tax liability once you file the sale of your home on Schedule D of your tax return. If the IRS notices that you did not properly recapture your depreciation, they may come after you for the difference. Let’s break down an example of how this may play out.
You buy a house in year 5 of your career, for $100,000. You live in it for 5 years, but move out & rent it until you reach 20 years & decide to sell it for $250,000. Great. You get to exclude your $150,000 profit. However, let’s assume that you took $30,000 in depreciation over that 10 years. That means you will probably owe $7,500 in taxes based upon the recaptured depreciation. Unless you decide to pursue a 1031 exchange (a completely different discussion) or not to sell your rental property, there’s no way out of this.
If you have other plans for your profit (like wisely investing in a diversified portfolio of index funds), you might not have the cash available when it comes time to pay the tax bill. It’s best to recognize this, budget the estimated tax for that year, and move on.
If you forgot to (or chose not to) depreciate this property, there are a couple of things to do. However, it does become tricky, burdensome, and is not within the scope of this article. You should definitely seek the advice of a tax professional–this is not TurboTax territory.
This video discusses depreciation recapture in more detail.
This article is by no means an adequate substitution for unbiased advice, based upon your personal situation. Before you make any major decisions, you should sit down with a fee-only financial planner or tax professional. Working with a professional is the best way for you to put together a plan that achieves your goals.