Q: I own a rental property in Florida. My primary residence is in Connecticut. I have owned the Florida property solely for four years. Before that, I owned it jointly with my late husband.
Do I have to pay capital gains taxes on the sale of the Florida rental property?
A: You may have to pay federal income taxes of one sort or another upon the sale of the Florida rental property.
When you sell a rental property, you will either have a loss, gain or break even. The net profit is generally calculated by taking the costs of purchase, the costs of sale, and the costs of capital improvements and subtracting them from the sales price of the property.
If you owned the property with your husband, I’ll assume that you owned it in equal shares of 50 percent. Let’s say you bought the property for $100,000 and when your husband died, it was worth $150,000. Your ownership share of the rental property remained at $50,000 and when your husband died you would have inherited his share of the property at a value of $75,000, which was the stepped-up basis.
If the property is now worth $300,000, you would owe taxes on your share and his share, which would be slightly less because of the stepped-up basis. If the property is now worth roughly what you paid for it plus expenses, then you wouldn’t owe any federal income taxes on the sale price but may owe other taxes. If the property is worth $50,000, then you’d have a loss, which your tax preparer can use to offset some types of income.
When people own investment properties, they get the right to depreciate the value of the property over many years. You get to use that depreciation to offset any income you make on the property, but when you sell the property, you have to pay the federal government back for the depreciation taken over the years. If you sold the property and made no profit, you would not owe any capital gains, but you might still owe recapture of the depreciation taken. The longer you’ve owned the property, the more you’ve taken in depreciation and the more you’ll have to pay back to the federal government.
If you don’t want to pay any taxes at all at this time, when you sell the property, you can use a 1031 exchange to defer any taxes owed on the sale of the rental property including capital gains taxes and recapture of depreciation taxes. You’ll have to find another rental property to buy in its place and use the proceeds from the sale of the current rental property to purchase that other property. Usually, the cost of the new property must exceed the cost of the property that was sold.
If you’re thinking of using a 1031 exchange, I encourage you to find a real estate attorney and qualified 1031 administrator to help you understand the rules you need to live by to make the exchange viable. You can’t sell the property and then decide to use a 1031 exchange. The decision to use a 1031 exchange to defer the taxes that must be paid must be made before you sell and close on the property.
Please consult your tax preparer for more details.