How do I avoid paying taxes when I sell my rental property? This reader wants to know if they can avoid capital gains taxes without doing a 1031 exchange.

Q: My wife and I are about to sell a Chicago rental property we purchased together. The house was our first home and when we moved out about seven years ago. 

After we moved out, we rented out the property. We transferred the property to our Schedule E on our personal joint income tax return, and when we sell, we should receive around $100,000 in proceeds. We would like to have the proceeds deposited in a company account and use the proceeds to buy and rehab properties, but we don’t want to do a 1031 exchange. 

How can we avoid paying taxes on these proceeds? Would that be a function of our adjusted cost basis on the property?

How Do I Avoid Paying Taxes When I Sell My Rental Property?

A: You’ve got quite a bit packed into a short question. Let’s start with whether you’re making a conclusion of the sale, we have no way of knowing if you have made a profit on the sale, and that’s key to figuring out how to move forward. 

In simple terms, you have to figure out what your costs were to purchase the home, the money you put into the home that is allowed by the IRS to be considered part of the “home,” and then the costs of selling the home. In much of the country, real estate values have grown since the Great Recession. However,  property values in Chicago haven’t done much and in many cases those values have gone down to levels last seen 20 years ago.

So, if you figure out that you’ve lost money, you may have no income taxes to pay even though you end up with cash once you close on the home. On the other hand, if you figure out that you have a profit, you’ll have a complicated time figuring out what your tax situation is. As a rental property owner, you probably took depreciation on the home and received a benefit on your federal income taxes. If you have to repay that depreciation, you’ll pay a tax of around 25 percent on the recaptured amount. 

How Depreciation Factors Into Profits From Home Sales

Here’s how it works: Let’s say you took $40,000 in depreciation over the time you owned the home. In this situation, you might owe $10,000 in depreciation recapture. And, if you have a profit of $50,000 on the sale of the home, you’ll likely pay up to 20 percent in capital gains taxes on that profit or about $10,000 plus some other lesser taxes. 

We’ve overly simplified the possible tax situation you might face, but in this scenario you’d owe around $20,000 in federal taxes plus a couple of thousand dollars to pay your state. 

Using a 1031 Exchange to Avoid Paying Taxes When Selling Rental Property

The only way we know that you can efficiently and effectively defer paying taxes on the sale of the property is by going the route of a 1031 exchange.

In the simplest of terms, a 1031 exchange allows you to sell your property, deposit all of the funds from the sale of the home with a 1031 exchange company — a special company that’s frequently called a 1031 exchange intermediary — then find a replacement property within 45 days of the sale and close on that property you found no later than 180 days after the date of the closing of the rental property you currently own.

While you might find some permutations of 1031 exchanges that might allow you to sell your home and then find a replacement property, do some rehab on that property and later own that same property, we wonder if those other options might be too costly given the amount of profit you’re expecting on the sale of the home.

If you’re looking to avoid any sort of tax bill, you’d better figure out what your cost basis looks like. If your tax exposure is quite small, you might be fine cashing out, then using the money to invest into other properties. On the other hand, if your tax exposure is great, you should speak with a qualified tax professional to help you figure out a plan of action well before you list the home for sale.

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