Understanding the calculation of capital gain when selling a rental property is crucial for smart financial planning. The first step in this calculation is to subtract the property's adjusted basis at the time of the sale from the total sales price. This must include any sales expenses such as legal fees and commissions. The resulting figure will be your capital gain on the sale. In order to provide a clear understanding of this process, we will explore this calculation using a hypothetical example in the following sections of our article.
Before we examine the hypothetical, let’s define a few key terms:
The adjusted basis is the original purchase price of an asset plus acquisition expenses and the cost of any capital improvements minus cumulative depreciation deductions and any deferred capital gains.
Long-term capital gains are the profits from selling an asset you have owned for over a year.
Depreciation recapture is a tax the IRS charges when an investor sells investment property to recoup depreciation deducted by the taxpayer in previous years. The depreciation recapture tax equals 25 percent of the total depreciation deduction taken for that asset.
First, determine your basis in the property. Suppose you bought the property for $400,000. This amount will be the starting basis unless it is lower due to previous 1031 exchanges, which may reduce the basis.
Second, add your acquisition costs. These expenses include title expenses, transfer fees, the cost of obtaining financing, realtor commissions, required surveys, and legal fees.
Third, add the cost of material improvements to the property. That includes building construction or renovation, landscaping, and other enhancements that add value to the property.
Fourth, subtract amounts that reduce the basis. These include depreciation deductions, reimbursements from insurance companies, and any canceled debts or payments received for easements.
Next, subtract that adjusted basis from the price you are selling for. The capital gain is the sale price minus the adjusted basis.
Suppose you bought the rental unit four years ago for $400,000 and had acquisition costs of $20,000. The starting basis is $420,000.
Next, you spent $50,000 to renovate the building, increasing your adjusted basis to $470,000.
$400,000 + $20,000 = $420,000
$420,000 + $50,000 = $470,000
Over the four years of ownership, you claimed depreciation deductions of $64,000, which reduces the adjusted basis to $406,000.
$470,000 - $64,000 = $406,000
If you sell this property for $600,000, the profit (gain) is $194,000. Since you owned it for more than a year, you will pay long-term capital gains taxes. The rate that applies to you depends on your overall income but is likely 15 or 20 percent. If you owned the property for less than one year, you would pay short-term capital gains taxes, which equal the higher rate on ordinary income.
Suppose your income level carries a 20 percent rate for long-term capital gains. In that case, you will pay 20 percent of $194,000, or $38,800. In addition, you will owe 25 percent of the depreciation deductions, or $16,000.
$600,000 - $406,000 = $194,000
$194,000 – $38,800 = $155,200
$155,200 - $16,000 = $139,200
Capital gains taxes can substantially reduce the net profit from selling a rental or other investment property. Investors interested in managing those taxes may want to consider deferral options such as a 1031 exchange to allow reinvestment of the entire proceeds from the sale.