Avoid Capital Gains on Rental Property Sale! - YouTube

Yo what's up everybody? Thanks for joining  me. Today I'm gonna be talking about rental  

properties and the, you know, what to expect when  you're selling them in terms of capital gains.  

What's all involved in capital gains and how you  can actually avoid capital gains and you know what  

things you can do there. So before we begin I  wanted to let you know there's two components  

in taxable gain when you're selling the property.  First there's the actual capital gain that  

everybody talks about and then there is something  called depreciation recapture which is kind of  

like capital gains, a little bit different.  And I'll go into the details of both and why  

it's important okay. So first, capital gains.  That is actually when you sell a property for  

higher than you bought it for okay. So in order to  calculate capital gains you take the selling price  

minus your purchase price minus any long-term  renovations that you made to the property,  

and then minus any selling expenses, you know,  like you pay out realtor commissions that kind of  

thing. That is your capital gains. Pretty simple  formula. Capital gains are typically taxed at  

15% for normal income ranged people. If you are  in the highest tax bracket then that that tax  

becomes 20%. And this is you know the 15% or 20%  only applies if you held the property for longer  

than one year. If you held it for less than a year  then you are paying ordinary income tax which is  

much less favorable. The other component to a  taxable gain of a sale is depreciation recapture  

and before I explain depreciation recapture,  I probably, you probably want to know what  

depreciation is. So when you purchase a property,  a rental property, let's say you buy one for  

$270,000 you don't get to just write off the  entire $270,000 in the year that you purchased  

it. That's just not how it works. What the IRS  requires is you depreciate the property over time  

okay. If it's a, if it's a business property you  depreciate over time. If it's your primary home,  

you don't have to worry about depreciating because  you're not using it for business. Now if you use,  

if you rent out like a room in your  house, you know for Airbnb or whatever,  

then you would depreciate a portion of your house  over time. So let's say you pay $270,000 for your  

rental property, you're expected to depreciate  over 27 years so that's $10,000 per year.  

That's the deduction that you can take each year  that you rent this property out is $10,000. That's  

called depreciation. So let's say you bought  it on the first day of the year in 2020 for,  

so for 2020 you'd depreciate $10,000. For 2021,  you'd depreciate another $10,000. So now you got  

a total of $20,000 of depreciation. Depreciation  recapture means that if you sell the property  

for greater than what you purchased it for you  have to take your total depreciation that you took  

and pay taxes on that depreciation as a  recapture. While you're renting the property  

out you're taking this depreciation deduction,  it's offsetting your income, it's offsetting your  

rental income, and in some cases could offset  your normal ordinary income as well, which is a  

good thing. But then when you sell the property  you then have to pay taxes on the depreciation  

recapture and that tax rate is up to 25%. So it's  not it's not a total wash, you know what I mean?  

Like if you are taking depreciation deduction  against your ordinary income, your ordinary income  

might be a greater tax percentage than 25% so when  you go to to recapture your depreciation you're  

paying up to 25% as the max. So you, it's still a  benefit to recapture that depreciation. So that's  

the two components in taxable gain when you're  selling your property. You've got capital gains  

and then depreciation recapture. Sometimes people  lump them both into the same terminology when  

they're talking about capital gains and I think  that's okay but for the purpose of this video  

it's really important to know the distinction,  when you're trying to avoid capital  

gains/depreciation recapture. So now I'm going  to talk about strategies on how to avoid capital  

gains or depreciation recapture. And you know if  you enjoyed this video, find it useful, please  

hit that like button. And also if you could please  consider subscribing to my channel I'm trying to  

put out as much useful content as possible for my  subscribers and to try to help you guys navigate  

the tax law. And navigate any relief covered  bills that get passed. So there are three primary  

methods that you can use to either avoid or defer  capital gains okay. So there's the 1031 exchange,  

you can hold your property until you die, and then  you can take the section 121 exclusion and I'll go  

over all three of these okay. So you've probably  heard a lot about the 1031 exchange if you are  

in real estate. It's basically, it basically  means that you have your business property  

and instead of selling it and paying capital  gains on it you actually, you take that business  

property you exchange it for another property and  you basically don't pay any capital gains tax when  

you do that okay. Now you're not actually avoiding  capital gains here you're just deferring it.  

You know any capital gains that you would have  paid on this property you're just moving it to  

your new property and then you're depreciating  it. You know, you continue to depreciate it. So  

it's a good way to move up in property without  paying capital gains tax immediately. And a 1031  

exchange covers capital gains and depreciation  recapture. Now some people think that you can just  

sell a property and then go buy another property  and then tell your tax guy "hey I actually just  

did a 1031 exchange, I just exchanged this  for this property". And that's not how it  

works. You actually have to go through a qualified  intermediary that does 1031 exchanges. Yeah it's  

like a very formal process you know, the the money  that you get from selling your first property gets  

put into a trust account and then you have to have  identified some other properties that you want to  

purchase within like 45 days. It's a whole formal  process, you don't get to just sell a property buy  

another one and then decide at that point that you  did a 1031 exchange. That's not how that works.  

So before you go doing that make sure you  engage with a 1031 exchange specialist.  

It's not, it likely won't be an accountant. Check  with your real estate agent or your title company  

to see if they know somebody that does that. The  second way to avoid capital gains is to hold on to  

your rental property until you die. You probably  heard this where you know, inherited property gets  

a step up in basis. Now what does that mean?  That means that you know, your purchase price  

that I talked about earlier as your cost  basis, if you die and you will that property  

to maybe your child okay. Your child gets a step  up in basis at the time of your death okay. So  

how you know, why is this avoiding  capital gains? How does that work?  

So basically you know I've seen some clients  where they bought a property like 20-30 years ago  

in Denver they bought it for maybe like $50,000  okay. Now it's worth $1.5 million. Can you imagine  

the capital gains on that, the capital gains  tax on that now, since it's worth 1.5 million  

dollars now and they passed away and they did  all things correctly their child inherited it  

now that property is worth $1.5 million  of cost basis to their children?  

So when they sell it immediately that's,  okay let's say they sell it immediately,  

they sell it for 1.5 million that means  you're taking your selling price $1.5 million  

minus their basis which is also $1.5 million  and thus you pay no capital gains there.  

So that's how you do it, by waiting, holding on  your property till death your children see the  

tax benefit there. Not necessarily you okay,  it's your children, but if you're looking for  

like more you know, estate planning generational  wealth building that's one way to do it. Another  

common thing that people think is that once you  die and you, you know, will a property to your  

decedents then the step up in basis is automatic  and that's not true. You have to file form 706  

which is an estate tax return to tell the IRS  that this property is receiving a step up in basis  

and this is the new basis at the time of death. So  some, some forms do have to be filed with the IRS  

in order for this to work. It doesn't just happen  automatically. So that's why it's really important  

when you're planning for your estate or when a  family member passes away to get in touch with  

the state planning attorney and a good CPA  to make sure that all those things happen  

and they get their, you know, step up the basis  and all that stuff. Now the third way to avoid  

capital gains tax is the section 121 exclusion.  And this is actually more commonly known among  

people who just own the primary residences. It's  the rule that says if you lived in your primary,  

if you lived in a home as your primary residence  for two out of the last five years, at least two  

out of the last five years, then you can exclude  up to $250,000 of capital gains per person.  

That means if you're married you can exclude  up to $500,000 of capital gains. Sounds great  

right? You know this, this just prevents people  from you know paying a bunch of capital gains  

for just wanting to move their family but  how does that tie into rental real estate?  

So one common thing that people might do is they  might move into their rental property for a couple  

years as their primary residence and that way you  can exclude, you know if they're married, you can  

exclude up to $500,000 of capital gains. Now this  method does not include depreciation recapture  

tax. So although, you know, you might exclude  capital gains, you still have to pay taxes on  

the depreciation recapture. This is also something  that I see accountants mis-report. You know very,  

very commonly they do not report this correctly.  So the taxpayers are out of compliance, you know,  

because there is depreciation on the property they  don't properly recapture it, so it's a big mess/.  

So just keep in mind if you do this strategy  hire a good CPA. Just mention that there has  

been depreciation on this, on this property, you  want to make sure it's accounted for correctly.  

Now when will this, when will this strategy make  sense? It would make sense if you've had the  

property for a long time and it has appreciated in  value significantly. Even though you'd appreciated  

the property for a while the capital gains is  still just enormous, this would make sense.  

Another thing to keep in mind is that the IRS  wants to make sure you rent out a property for  

at least a year before you move into it as your  primary residence. I mean the longer the better  

because then you know, you can legitimately  say it was a business property before  

you moved into it as a personal property. And  this is actually important if you choose to do  

a 1031 exchange into a new property. Some people  do that and then they move into their new property  

as their primary residence. And while that,  while you can do that I would wait as long  

as as you can, you know, to make sure. Because  the 1031 exchange is the exchange of a business  

property for another business property, so  you can't exchange it for a personal residence  

okay. So you exchange it for a business  property you should wait as long as possible  

before moving into that property  if that's what you plan on doing,  

to avoid any trouble with the IRS. Three ways to  avoid again, there's a 1031 exchange, there is  

holding until you die, and then there is moving  into your, your rental property and living in  

there for at least two out of five years. Oh one  more thing I want to talk about is there are some,  

I've had a huge number of clients who did  their own taxes on Turbo Tax and Turbo Tax did  

not depreciate their property for them, their  rental property. So as I said before, the IRS  

requires you to depreciate your property if it's  a rental or if it's used for business purposes.  

And for some reason Turbo Tax might not make it  clear, you know, I don't, I haven't really touched  

Turbo Tax in a while but they had their rental  property for maybe 10-15 years and never took  

any amount of depreciation on it, So what  happens there is when you go to sell the property  

you then have to still pay depreciation recapture  tax even if you didn't take the depreciation. So  

in this case you didn't get the benefit of  the depreciation deduction on the front end  

and now we have to pay the taxes for it on  the back end, so now you're doubly screwed.  

There's one way to get out of this though  it's called the change of accounting method.  

And we've done this for all of our clients who  have this issue where you basically can take all  

your missed depreciation and lump it into the  year that you sell the property. And it just  

offsets the depreciation you capture that way.  So that's filed with form 3115 if that is your,  

if that is what happened to you. Be sure to  reach out and we can help you with that. It  

could save you tens maybe hundreds  of thousands of dollars all right.  

That's all I've got for today. Thanks  for joining me. Again my name is Ryan,  

I'm a CPA. Be sure to like this video if you  do like it and found it helpful. And I would  

ask that you consider subscribing to my channel  to stay up to date with all these tax changes.  

Covid relief changes, all that crap all right.  So stay safe. Take care. I'll see you next time.