Correctly reporting the sale of rental property to the IRS is crucial since doing it wrong can result in paying the wrong amount or even having a penalty assessed, and no one wants to do that. Of course, planning for the transaction before executing it is even better than determining the correct reporting after the fact.
If you sell a rental property or any other real estate asset that you use to generate business income, you need to report the sale using Form 4797 or Form 8949. Most deals are reportable with Form 4797, but some use 8949, mainly when reporting the deferral of a capital gain through investment in a qualified opportunity fund or the disposition of interests in such a fund. Use Form 4797 for sales, exchanges, and involuntary conversions.
What Will I Owe When I Sell a Rental Property?
You will pay tax on the capital gain, if any, and depreciation recapture. What does this mean? The capital gains tax assessed by the federal government and most states is an amount due on the profit realized on the sale of an asset. The capital gains rate is typically lower than you would pay on ordinary income, but still, it reduces the profit in selling your property. Remember that if you sell an asset you have held for less than one year, you will pay the higher ordinary income rate.
Capital gains rates for 2022 are assessed at zero percent for taxpayers with taxable income up to $41,675 for single filers ($83,350 for those married filing jointly) and reach twenty percent for single filers with income over $459,750 or $517,200 for couples.
The depreciation recapture procedure is more complicated than capital gains. It is the process by which the IRS collects taxes back on an asset that a taxpayer sells, which they have previously used to offset income via depreciation. For example, if you have claimed depreciation of $10,000 while you owned the property, you could have to pay back $2,500 in depreciation recapture when you sell it if the recapture rate is 25%.
What if I Incur a Loss Instead of a Gain?
The good news is that the IRS won't tax you on the money you lost. If you sell a capital asset for less than your basis (the purchase price plus adjustments like money spent on the acquisition and any improvements minus your depreciation deductions), you won't have a capital gain to report. However, you can use a capital loss to offset the tax you owe on a different investment gain. If you have more losses than gains, you can cancel as much as $3,000 in ordinary income and carry over any additional capital losses for the following year.
How Can I Avoid Paying Taxes When I Sell a Rental Property?
If you plan for the transaction and complete a 1031 exchange, you can defer the capital gains and the depreciation recapture on a business property sale. A 1031 exchange is trading one investment property for another "like-kind" asset of equal or greater value, as laid out in the Internal Revenue Code section 1031.
It’s critical to plan ahead because one essential element of a successful 1031 exchange is that the proceeds from the sale are not available to the taxpayer. The exchange is handled using an intermediary who safeguards the funds from the time of the initial property sale until a replacement asset is identified and purchased. Any lapse in the protocol will result in disqualification of the exchange, and taxes will then accrue on the gain.
If you complete a 1031 exchange, you will also need IRS Form 8824 for the tax year in which you execute it. The form calculates the amount of gain deferred due to a like-kind exchange of property. The IRS considers the deal completed in the tax year that you sell the initial relinquished property, and the exchange period begins. If you do not finalize the replacement purchase or purchases until the next tax year, you will need to request an extension for tax filing due to that circumstance.