what are hidden costs when selling a rental property.

Question

I was told that when a rental house is sold, we would have to "pay back" costs like replacing hot water heaters, HVAC, replacing carpet, painting, etc. that we previously used against income from the rental business and a profitable pet/house sitting business.

I am confused by this and not even sure I am asking in the correct forum. Any guidance would be appreciated.

Linda Weygant · Answer

It can make a lot of sense to sell a rental. Here's how it works:

You buy a house for $275,000 and hold it for 5 years. Depreciation on this is $10,000 per year, so your depreciation is $50,000.

You sell the house for $350,000.

Your basis is now $275,000 - $50,000 = $225,000 so your total profits are $125,000.

Of that $125,000, $50,000 is depreciation recapture and $75,000 is capital gains.

If you're in the 25% tax bracket, then you pay tax on the $50,000 at 25% or $12,500.

The capital gains taxes are 15%, so you pay $75,000 at 15% or $11,250.

So you've profited $125,000 and paid $23,750.00. You walk away with $101,250.

Doug McLeod · Answer

Check with a CPA - if you fully expensed some things that the IRS expects would have been depreciated, there might be something like that - but otherwise those are all totally legitimate business expenses/deductions. Otherwise, those things would be part of your basis and being depreciated. Depreciation "add back" will likely incur tax (whether depreciation on original purchase/rehab or later improvements).

Kevin Harrison · Answer

@Linda Weygant, this is the most concise and easy to understand explination of depreciation recapture I have ever read. thank you.

Doug McLeod · Answer

1031 is best way but strict rules. If enough appreciation and equity capture/pay down and you have held long enough to get long term cap gain rate, paying the taxes may still leave you with sufficient margin for it to make sense depending on what your goals are.

Chelle Knijnenburg · Answer

@Doug McLeod and @Linda Weygant

Thanks so much. The question I was asked was - does it makes sense to sell a rental? and how do you make money selling a rental? My assumption is that the rolling over into a 1031 exchange is the only way to avoid a huge tax bill.

Linda Weygant · Answer

You'll have what is known as "Depreciation Recapture", which would indeed have been based on things like water heaters, HVAC, etc. This is taxed as regular income.

what are hidden costs when selling a rental property.

what are hidden costs when selling a rental property.

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