Thinking About Selling an Investment Property? Start Here to Know Your Options.

We’ve discussed the compelling reasons to consider purchasing an investment property and why it can be a good addition to your portfolio. But now you’ve purchased your investment real estate, managed it, and are ready to move on. You’re not sure what you’d like to do next, but you know you no longer want to manage your current property.

Below are the core questions every investor should work through before deciding what to do with their investment property and the options available to them.

1. What are your goals for your next investment?

It sounds basic, but many investors jump in and out of investments without articulating the “why.” Are you looking for:

• Continued monthly income?
• The same strategy, but with a different property?

• Continued investment in the real estate market?

• A property you might eventually retire to?
• Additional investment growth opportunities?
• Less management responsibilities?
• To diffuse, defer, or potentially avoid taxes?

Each goal leads to different selling decisions. For example, if you want to defer taxes that may arise from the sale of a property and are comfortable continuing to manage rental real estate, then a 1031 exchange into another rental property could be the right answer for you.

If you want to stay exposed to real estate while potentially deferring taxes from the sale of a property, but no longer want the burden of managing property directly, then a 1031 exchange into a DST or, depending on the structure, a separate 721 UPREIT transaction could make the most sense.

If your gains on the property are manageable and you’d like to put your money back in the market for more aggressive growth opportunities, then an outright sale might just be the answer.

Define the finish line before you start, it’s a lot easier to decide on your next step when you have a clear goal in mind.

2. What are the tax implications for selling your property?

Gain from an investment property sale is often taxed at capital gains rates, which may be more advantageous than ordinary income tax brackets. However, there can be additional complications and factors feeding into the taxes you pay when selling an investment property, including potential state tax consequences depending on where the property is located and where you file.

The following should all be evaluated and estimated before deciding to sell your rental property:

• Capital Gains
• Depreciation Recapture
• Passive Activity Losses

Capital Gains

Start with the basics: gains on the sale of your property will generally be measured using your adjusted basis, not just what you originally paid versus what you sold it for. Adjusted basis can reflect items such as capital improvements, depreciation, and certain other adjustments. The majority of property owners will have owned their property for more than one year, meaning at least a portion of the gain may be subject to advantageous long-term capital gains tax rates.

Your adjusted basis will be one of the most important points of clarification for how much tax you might be on the hook for when selling a property, so make sure you have a good idea of what it is before making any decisions.

If you need help finding or calculating your adjusted basis, reach out to your Allworth advisor or tax professional for assistance.

Depreciation Recapture

The upside of taking depreciation on your rental property is that those deductions can offset annual taxable rental income. The downside is that when you sell the property, the portion of your gain tied to depreciation may be taxed at rates up to 25%, depending on the situation, rather than being fully taxed at lower long-term capital gains rates.

As an example, if you’ve taken $100,000 in depreciation on a property since owning it, up to said $100,000 portion of gain may be taxed at the 25% rate depending on certain factors. This would be on top of any other capital gains tax that may apply once you decide to sell the property.

Net Investment Income Tax (NIIT)

If your MAGI is above $200,000 if you are single, or above $250,000 if you are married filing jointly, you could also be subject to Net Investment Income Tax, or NIIT. NIIT is generally a 3.8% tax that may apply to some or all of your investment income if your income exceeds certain thresholds. It does not automatically apply to the full sale proceeds but should be something to look out for when reviewing your potential tax liability.

Passive Activity Losses

One potential tax upside to the sale of a rental property is the treatment of suspended passive losses accumulated over the years.

For tax purposes, rental real estate is generally considered a passive activity, meaning losses from the property typically can’t be used to offset income like wages or portfolio income in the year they occur. Instead, those losses are often carried forward.

In general, when you dispose of your entire interest in the activity in a taxable transaction, those suspended passive losses are released and may be used to offset the gain from the sale and, depending on your situation, potentially other income as well.

If you have multiple properties and are looking to sell an unprofitable one, this can be a major tax-planning opportunity.

3. Reducing Taxes

If your living arrangements are flexible and you are looking to reduce the tax burden from the sale of a property, you could explore the primary residence exclusion if you’ve lived in the property for 2 of the last 5 years. This may allow you to exclude up to $250,000 of gain if single, or up to $500,000 if married filing jointly.

As an example, if you are married and sell a property for $2 million with an adjusted basis of $700,000, your total gain would be $1.3 million. If you qualify for the primary residence exclusion, you could exclude up to $500,000 of that gain, leaving about $$800,000 still potentially subject to tax.

It’s important to know this would not eliminate depreciation recapture and, depending on how long the property was used as a rental, some gain may not be fully eligible for exclusion. In many cases, the exclusion can reduce taxes substantially without eliminating them entirely.

4. Diffusing Taxes

If you’ve decided to sell your property and have a large amount of capital gains and depreciation, an installment sale may be worth considering. This can allow you to receive multiple payments from the sale, spreading out capital gains over several years and potentially keeping you in a lower tax bracket during that time.

This is not a silver bullet though, since any depreciation may still need to be recaptured in the year of the sale. Essentially, an installment sale can help spread out capital gains taxes, but not necessarily depreciation recapture taxes.

This strategy can lessen overall taxes by spreading out capital gains over a given time period, but it will not eliminate taxes or capital gain recognition. It’s important to note that an installment sale will also delay the time until you receive the full proceeds from your sale of the property. This means that if you need the money sooner or are looking to reinvest the proceeds in the market, you may have to wait.

5. Deferring Taxes

Two strategies that often come up for investment property owners looking to move on from their current property without recognizing depreciation or capital gains are a 1031 exchange and a 721 transaction. While they have some similarities, it’s important to understand how they are structurally different. Depending on the structure of the agreements, these strategies may allow for tax deferral.

Generally speaking, the objective of each exchange is to:

• 1031 Exchange – swap your current property for another property or an interest in a Delaware Statutory Trust (DST) in some cases
• 721 Transaction – contribute your current property to an UPREIT structure in exchange for partnership units

For clarification, a DST allows multiple investors to pool resources to invest in larger real estate properties. By working with a Qualified Intermediary (QI), a seller may be able to use 1031 exchange proceeds to acquire a professionally managed DST interest. This is subject to strict timing and structural requirements.

In contrast, a 721 UPREIT generally allows property owners to contribute their property to a REIT’s operating partnership in exchange for partnership units, potentially defer taxes, and gain access to a broader real estate portfolio rather than the continued ownership of the original property.

These strategies can become very complex and should be discussed with your Allworth advisor and tax professional before pursuing.

6. Don’t Forget About Those Pesky State Taxes

Each state has their own taxes and rules for selling a property that can throw an expensive wrench into your plans if unaccounted for, so make sure to keep them in mind.

If the property you’re selling resides in a state other than the one you’re currently living in there could be further tax complications. This makes it all the more important to speak with your financial advisor or tax professional early, so you can factor state tax consequences into your decision-making.

The Bottom Line

While far from an exhaustive list, these are the most common considerations and options for selling or exchanging your investment property. In the end, this will all come down to your specific goals and what you are looking for from the investment.

Once you know what your goals are, talk to your advisor so that you can begin working through which options and strategies best fit your needs. A well-planned strategy can make a world of difference.

This information is meant for educational purposes and not as direct tax or legal advice. Rules and regulations can shift anytime, so it’s always best to consult a qualified tax advisor, CPA, or attorney for guidance tailored to your specific situation.