One of the trends this year of low mortgage interest rates and during the COVID pandemic is that private landlords are finding it to be great time to sell their rental properties. Good for them, not so good for their tenants who may have to find a new place to live in a very tight rental market.
Many landlords haven’t sold before. Some are military service members and others who converted their homes to rentals when they moved because they thought it would be a good idea. For others it was a planned investment. But for those that haven’t sold before, they should put some thought into the tax consequences of the sale. Best not to be surprised by a big tax bill and possibly penalties for not paying when the IRS prefers you to pay.
Selling a house for more than you bought it usually means you have had a capital gain. Capital gains are generally taxable. In some cases an exclusion of the capital gains for a home sale is available. For all home owners, if they lived in the house for 2 years of the past 5 years, they can exclude up to $250,000 of gain if single and up to $500,000 of gain if married. There are special rules for military and some others to suspend this 5 year period for 10 years, basically they can turn this “2 of 5” rule into a “2 of 15” rule. There are qualifying criteria for each rule. And there are some cases when a partial capital gains exclusion is available if the taxpayer(s) lived in the house less than 2 years. Yes, the IRS has no lack of rules and instructions for taxpayers.
So if your capital gains are excluded you have nothing to worry about right? Wrong. If you as the homeowner depreciated the house or if you should have depreciated the house (most landlords should depreciate) then the IRS wants to apply “depreciation recapture”. Basically when you sell they want you to pay some for the tax benefit of depreciating prior years-even if you didn’t do it when you should or could have. That is a simple, although not perfect explanation.
So what is an exiting landlord to do? Well, project your taxes owed, preferably before the sale and update your projections after the sale. And pay your taxes in a timely manner. If you are already familiar with IRS instructions, depreciation, and if you have been doing your own taxes as a landlord you may be able to handle this on your own. But selling adds a new level of complexity to your tax returns and often, especially this year it is “big” money. In my experience tax returns with rental property have a high error rate, and this may be a year to consider getting a tax consult from a professional to help you to do projections and determine if you should pay some estimated taxes. It may also be the year to have a tax professional prepare your tax returns. If you already have a tax professional who does your taxes, then contact that professional and ask them for some projections and to calculate how much estimated taxes you should pay if any.
Above all, be proactive and make sure you don’t get a big surprise when you file your tax return.