# Beware of Taxes When You Sell Rental Property

One of the things I deal with every year is a client who sold a rental property and they have a capital gain from it, and the client is not pleased.

The conversation always follows the same course. “I sold the rental for about the same as I bought it for, so no big deal.”

And then when the big tax bill hits because of the sale, the client is shocked. How could this happen when they sold it for almost the same as they bought it for 25 years ago????

So let’s look at this more closely.

## Depreciation Deductions

When you own a rental, you claim depreciation against the price of the property (NOTE: only against the house, not the land). The depreciation deductions reduce your basis in the house. When you sell the property, your gain is based on your basis in the property. Depreciation deductions = yearly reductions in your basis. Reductions in your basis = the chance for a big gain to report at tax time.

Example:

You bought a rental property for \$275,000 in 2002. Rentals are depreciated over 27.5 years because that is what the IRS says. So you’ve gotten depreciation deductions of \$10,000 per year*. Let’s say you sold the house on December 31, 2019, so you had 18 years of depreciation deductions. 18 x \$10,000 = \$180,000 of depreciation taken through the years.

*-Note: I am simplifying for the sake of this example. In reality the 2002 deduction would be a smaller pro-rated amount, and the same thing for depreciation in the year of sale. Also let’s say this is a condo so the land doesn’t come into play, so the entire \$275,000 is depreciable. This is an example so I am going for simplicity!

Let’s say you sold the property for \$280,000. That’s only \$5,000 more than you bought it for all those years ago. But your gain is based on your basis, which is actually \$275,000 – \$180,000 of depreciation deductions = \$95,000. So your gain is \$280,000 – \$95,000 = \$185,000.

## The 1031 Exchange Option

Using a Section 1031 exchange, you buy a new property and roll the gain from the old property into the new property as a reduction in basis in the new property. The gain is deferred until sometime down the road when you sell the new property (or you could do another 1031 exchange and continue the process of deferring the gain).

In reality, I find three things are true here:

1. Very rarely do rental owners even tell me they are selling the property (like, it almost never happens even if I bring up that they should talk to me about things like this). They just go ahead and do it, and don’t tell me about it until long after the Section 1031 dates have passed (you must identify the new property and close on it within certain timeframes, and those timeframes are almost certainly missed by the time the client tells me about it).
2. Section 1031 exchanges almost certainly will require you to use an intermediary. Whenever a client mentions Section 1031 to me, I tell them to find a company that can facilitate the transaction. This costs money.
3. The vast majority of normal clients — at least the ones I deal with — are not rental tycoons or even committed rental owners. To be blunt, most of them are miserable and complain about their rental(s)! I know from personal experience. I used to own a rental, and at first I thought I was going to become a big-time rental tycoon. It didn’t happen; instead I ended up hating everything about the rental I owned. And so selling the rental is like loosening a huge weight from around your neck. I know from personal experience — that’s how I felt when I sold the stupid rental I used to own! If you do a 1031 exchange, you must do it on a new rental, meaning you are staying in the rental game. Is that what you want? The tax hit this year might be worth it just to get rid of the property and the headaches of owning rentals. And — again speaking from personal experience here — don’t underestimate the headaches involved with owning rental property.