On Monday, I advised a reader that she should keep her rental property that provides positive net rental income and is creating equity without cash from her and her husband.

She also wanted to know the tax consequences if she and her husband did decide to sell, so I want to touch on that today.

Here’s what she and you need to know:

The Basics

Your profit or loss on a rental property, like most other investments, depends on the sale price of the property minus your adjusted basis.  Your basis in the property starts with its cost but can also get increased or reduced given certain events (hence the word “adjusted” basis).

Some examples of events that increase your basis include:

• The costs of additions or improvements
• Legal fees related to the property
• Amounts spent to restore the property after it’s damaged

A reduction in basis can come from:

• The amount of any insurance or other payment you received as a result of a casualty loss or theft
• Any deductible casualty loss not covered by insurance
• Amounts depreciated on your income tax return

So, for example, if the reader original purchased the property for $150,000, made $50,000 in improvements, but also depreciated $40,000 on her tax return, her adjusted basis would be $160,000. 

If she ends up selling the property for $250,000, she would realize a $90,000 profit (or gain) from her investment.

The Depreciation Recapture Wrinkle

The most common reduction in basis comes from depreciation.

Simply put, depreciation is an annual allowance for the wear and tear on a property. It allows you to recover the property’s cost over an extended period of time. 

You can start claiming depreciation when you put the property into service for use in a trade or business. You can no longer take depreciation when you recover the full cost and other basis.

You deduct depreciation for a rental property on the schedule E, along with other rental expenses such as mortgage interest, taxes, insurance, maintenance, and repairs.

However, the tax consequences for profit due to the recapture of depreciation are a bit different.

The tax rate for the amount of profit due to depreciation – in my example above $40,000 – would be taxed at 25%. The rest of the gain $50,000 would be taxed at the long-term capital gains rate (currently 15% or 20% depending on your income).

So you may find yourself calculating a combined tax rate on your schedule D. Luckily the IRS offers a handy worksheet when trying to figure it out. (Or you could always just leave it to your tax advisor.)

Is There a Way to Avoid Paying Taxes?

If the rules sound a little confusing it’s okay: they are. As with most things in the tax code there are rules, exceptions, and exceptions to the exceptions.

There is even a way to defer paying tax on any profit by investing in another rental property. This is called a 1031 exchange and will have to be its own blog post.

Lastly, because the reader lived in the property before it was rental, there may be an additional way for her to avoid paying tax on some of the profit. Tune in on Friday for that tip.