In contrast to shares, which can be sold even with a few clicks from our smartphones, rental or investment properties take time and effort to sell. After taking the decision, it might take weeks or months to sell the property. Selling an investment property can become an overwhelming process.
While dealing with investment properties, the realization of capital and taxation issues can complicate the process. However, it does not make it impossible to accomplish. In this article, we will look at the way to reduce taxes on gains and the process of selling an investment property.
Reasons for selling investment properties
It varies from person to person so why would one choose to sell their investment properties? Mostly, if the landlord decided to move, they may find it hard to maintain their property and choose to sell it. Or simply a landlord may require a large sum of cash from his needs which rental income wouldn’t have fulfilled. If the property is losing worth, it may be one of the reasons why the proprietor chooses to sell their investment property. Whatever the reason is, selling an investment property will have the same consequences for taxation purposes.
Dealing with the Taxes
The sale of rental property proves to be much more expensive in terms of taxes as compared to simple property for personal use. The capital gains tax liability that arises on the gains from proceeds after selling the rental property is calculated by adding any depreciation charged against the property during ownership. So, all the losses that you claimed to reduce your tax liability during the years add up to create an even more taxable charge when sold.
Example – Capital Gains Tax and Depreciation
Assume, Mr. A bought a rental property costing $200,000 and it sold for $250,000. In normal circumstances, you will have to pay a capital gains tax of $50,000. Let's assume that they deducted $20,000 as a depreciation charge since they owned the property. Now, while calculating tax liability, the gains are calculated using the sale price deducting the purchase price from it, but the purchase cost used would be reduced by $20,000 claimed as depreciation: $250,000 – ($200,000 – $20,000) = 70000. This value is used to calculate our gains tax.
Note: This is not to discourage people from claiming depreciation, because it is always desirable to reduce tax liability as soon as possible.
The Internal Revenue Code Section 1031 allows real estate investors to reinvest in similar property and claim tax reliefs. Tax consultants or lawyers are a great help in this area, you can sell a property and use its proceeds to buy a similar property and avoid taxes. However, there is a restriction to choose a property within 45 days (about 1 and a half months) and 180 days (about 6 months) to complete the transaction.
So, if you have the intention to buy a similar property with the sale proceeds, it would be great if you looked for a new property before selling the first one and claim rollover as much as possible.
But the problem with a rollover is that it only works if you intend to reinvest in another property. If you are selling just because it's getting hard to manage, try hiring a professional manager or you can sell and reinvest in a property that is managed by a professional property manager. However, if you are just intending to sell and raise cash, you will have to bear capital gains tax.
If you have made up your mind to reinvest in a similar property, it can be an intimidating and complex process. So, it is recommended that you hire a full-service 1031 exchange company with a good reputation to do the work for you. It will be a great help to ensure you obey all the rules and regulations and avoid any missteps.
Using Corporation as a Shield
Incorporation is gaining popularity among real estate investors. People use corporations as a shield between themselves and the potential tenants as their finances are secure when you incorporate them. Also, corporations have their own taxation rules, although they are favorable, especially with the taxation gains arising from selling a property.
Some real estate investors can highly utilize and gain benefits from incorporation. For those who have employees hired to find them investable properties and have a wide range of investment properties, being incorporated would prove beneficial for them as it will reduce their tax liability.
You can easily form an incorporation by hiring a consultant or a lawyer. However, incorporation will create complications when you are going to sell the property because then you will be selling something from your corporation which is more complex than selling your property, as you are standing on the line of tax evasion and tax avoidance.
Would it be beneficial to incorporate two or more properties?
A simple answer would be no. If a person is holding two or three properties whether self-managed or managed by a professional, it would be better for them to hold them as it is, write off any expenses and depreciation against incomes, and do not go for incorporation until they are getting a significant margin after their expenses.
In some states, real estate investors are allowed to create a separate limited liability company for every property they own. However, it will not reduce taxes or have any effect on their tax liabilities but will provide a safeguard for their finances and properties from any litigations that might occur against them.
Investment properties are difficult to sell and reducing the tax liabilities arising from its gains can be a problem for real estate investors. Although, if you are selling to reinvest in similar properties, you may have the advantage to roll over and claim tax reliefs.
There is always an option to incorporate or create a limited liability company for your properties to have a shield against legal actions and provide an extra safeguard to your finances.