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.
