Nearly every real estate investor must sell their rental property at some point in their career.
It takes more than just working with a local realtor and hosting an open house to sell a rental property. In fact, there are situations when selling unconventionally might be more successful.
You might want the cash, a new property (which, if done through a 1031 exchange, can assist you to avoid any capital gains tax paid to the IRS), or to completely leave the rental property industry.
Before discussing how you can sell your rental property, let’s first discuss in this article how to minimise the tax bill you’ll receive on the proceeds of your sale.
Tax-efficient methods for selling a property
It’s crucial to emphasise that there are a few tax-efficient alternatives to selling the property.
One way is by using a 1031 exchange, which helps put off paying both short-term and long-term capital gains tax. Depending on the amount of profit you make from the sale of an investment property, you can be subject to significant capital gains taxes. Federal taxes will be the most noticeable of these. According to the IRS, the amount can vary depending on your income, but in most cases, federal capital gains taxes can range from 15% to 20%.
Profit may also be subject to state-level taxes on gains or income, depending on where you live. According to Investopedia, accumulated rental property depreciation recapture is taxed at a federal rate of 25% with varying rates at the state level, and will also need to be resolved. Accumulated depreciation recapture refers to the tax deductions you received by depreciating your asset over the course of the time that you owned it. For a better grasp of your personal tax implications based on your position, speak with your CPA without a doubt.
However, if you correctly complete a 1031 deferred exchange, you might not have any tax liabilities at the time of sale.
A 1031 deferred exchange, also referred to as a “like-kind” exchange according to Investopedia, enables users to postpone capital gains taxes if proceeds are reinvested in a new property or portfolio of properties with a value that is equal to or higher than the original investment, and loan amounts that are comparable to or higher. Although there are many other factors to take into account, these two are the most significant.
There are normally no restrictions on how many or how frequently you can do a 1031 deferred exchange as long as you keep your properties for a long enough period of time and avoid triggering “dealer status” with the IRS (typically a two-year-old or more).
Selling your principal residence can result in a significant additional tax benefit. Why include a primary residence when this post is about investment properties? Anyone who buys a primary residence and later converts it to a rental property may be eligible for this tax deduction.
There are a few restrictions, so you should talk to a tax expert to see if you might be eligible. The requirement that you must have lived in the property for 2 of the previous 5 years—it doesn’t have to be all at once—is the toughest obstacle to overcome.
Therefore, if you bought a primary residence, lived in it for two years, moved out, converted it to a rental, and have owned it for three years or less as a rental, it might be an advantageous moment to sell from the perspective of tax savings.
6 Things to Consider Before You Start to Sell Your Rental Property
Once you’ve made the decision to sell, take the following actions before putting your rental property on the market:
- Decide who your ideal client is
Decide who your target customer is before anything else. Your present tenant, a different real estate investor searching for a turnkey rental property, or a buyer looking for their own house could all be the potential renter. What you do with an existing tenant and how much you price your house depends on who your target buyer is.
- Select a pricing strategy
Investors in rental property can be more inclined to spend more for a house that is already rented to a reliable renter. This is due to the fact that cash flow starts the day escrow closes, saving the new owner the time, hassle, and lost rental income that would otherwise be required to find a renter.
On the other hand, if a tenant or owner-occupant decides to purchase your house, they most likely won’t spend more than the value of your property as determined by recent real estate comparables.
- Make repairs and have a pre-listing inspection ordered
Having the buyer’s inspection come back flawlessly clean is one of the finest methods to receive top money for your rental property.
Pre-listing inspections can help you identify any repairs that need to be made before you put your house on the market. This way, the buyer won’t have to worry about the state of the house.
- Let your tenant know
Inform your current tenant that the property will be up for sale. They’ll probably be worried, so make sure to let them know how the security deposit and lease will be transferred to the new owner.
Set up a showing schedule that won’t be too disruptive to the renter while also assisting you in attracting qualified purchasers quickly. To encourage the tenant to cooperate with viewings, think about offering them a perk like free weekly cleaning or an Amazon gift card.
- Analyze liens
If you have a mortgage on your investment property, the lender has a lien on it that is released when the house is sold and the mortgage is settled at closing. You might, however, be fully unaware of other encumbrances, such as a mechanic’s lien.
To make sure that your property transfers to a new owner free and clear, ask your escrow officer to perform a title check and take care of any lien issues beforehand.
- Investigate capital gains
You’ll have to pay tax on the depreciation recaptured as well as any remaining capital gains when you sell your rental property. The effects of selling a rental property on taxes will be covered in more detail towards the conclusion of this article.
But for now, be mindful that long-term capital gains tax rates currently range from 0% to 20% depending on your income level, while depreciation recapture is taxed at a maximum rate of 25%.