Unlike selling a stock, investment properties can't be unloaded in a few seconds with a click of your mouse. The time between the decision to sell and the actual date of sale is often measured in weeks or months. Selling your own home can be an intimidating process if you don't know where to start, but selling an investment property requires even more work.

The amount of capital and the taxation issues surrounding the realization of that capital are complex when dealing with investment real estate. It is not, however, impossible to accomplish on your own. In this article we'll look at the process of selling an investment property and focus on how to limit taxes on the gains.

Why Sell?
The reasons for selling a rental property vary. Landlords who personally manage their properties may move and want to buy a different investment property near their new residence. Or, a landlord may want to cash in on the appreciation of a rental property rather than accumulating money through rent. It may even be a case of a property that is losing money, either through vacancy or not enough rent to cover the expenses. Regardless of the reason, real estate investors looking to sell will have to deal with taxes. (To read more about rental properties, see Investing In Real Estate and Five Things Every Real Estate Investor Should Know.)

The Tax Man Cometh
The capital gains taxes on a rental property sale are much steeper compared to the straightforward sale of a personal use property. The basic capital gains that you have to pay on the profit from the sale are increased by any depreciation you claimed against the property. This means that if the property lost money and you used the loss against your tax bill in previous years, you will have a larger tax bill when the sale goes through. (To read more about capital gains and taxes on your rental property, see Smart Real Estate Transactions and Tips For The Prospective Landlord.)

Example - Capital Gains Tax and Depreciation

Let\'s say you have a rental property that you bought for $150,000 and it sells for $200,000. Usually, this means that you pay capital gains on $50,000. If you deducted $20,000 in depreciation over the time that you owned the property, however, you owe the difference between the sale price and your purchase price minus depreciation: $200,000 - ($150,000 - $20,000). Instead of owing capital gains on $50,000, you now owe capital gains on $70,000.
Note: This shouldn\'t discourage you from claiming depreciation losses. It is almost always better to realize tax breaks sooner rather than later.

Rolling Over
The Internal Revenue Code Section 1031 allows real estate investors to avoid taxes on their gains by re-investing them in a like-kind property. With the help of a lawyer or a tax advisor, you can set up the sale so that the proceeds are put into an escrow account until you are ready to use them to buy a new property. There is a time limit of 45 days to choose the new property and six months to complete the transaction. If you intend to do a rollover, you should start looking for the new property before you sell the old one.

The 1031 exchange works great if you intend to re-invest in another property. If you merely want to stop being directly involved with property, you can either hire a professional manager for your current property, or sell it and buy a professionally managed property. If your goal is purely to raise capital, however, you will just have to eat the capital gains tax.

Incorporating as a Shield
Incorporating is becoming increasingly popular for real estate investors. By incorporating, investors can lessen their personal liability making the corporation act as a shield between you and the potential that a tenant may sue you. Your house and personal finances cannot be claimed in any kind of court settlement when you incorporate. Corporations also have different tax rules that are quite favorable, especially with the capital gains from selling a property.

For a certain type of real estate investor, incorporation makes sense. If you are employing people to find and manage a wide range of income-producing properties and making significant profits at it, incorporation will lessen your tax bill and then you will see the profits through the share structure of your corporation. For most real estate investors, there are better ways to get the benefits of incorporation without complicating how income is realized.

Incorporation can create a barrier between you and the earnings from your property so that if you depend on that income in any way, you may not be able to access it as easily as you'd like - particularly with large profits such as those from selling a property. It is comparatively easy to incorporate, requiring only some professional advice and paperwork, but getting your properties out of a corporation (for example, to sell them off and retire) is more complex because you are walking the line of intentional tax evasion/fraud unless you sell the corporation instead of the properties that make it up. This is, of course, much harder than selling a house.

In contrast, if you are personally managing two or three properties and have even one or two more that are professionally managed, you may not benefit from incorporation. If the income from your rentals isn't outpacing your expenses for each property by a large margin, you are better to hold them as is and use depreciations and write-downs where you can, or change your real estate holdings into a small business.

In addition to using a small business as an alternative to incorporation, some states allow real estate investors to open a separate limited liability company for each property they own. While this doesn't necessarily lessen the taxes, it does protect your own finances, as well as each individual property, from any litigation that may be carried against one of your properties.

Conclusion
Selling a rental property can be challenging, and it is even harder if you are hoping to avoid a large tax bill on the proceeds. If you are selling in order to invest in a different property, then you can simply do a 1031 rollover and put off the tax bill. If you are selling because you need the capital, you will have to pay some taxes. The best-case scenario, as with stocks, is to put off selling an investment property, especially a rental that is breaking even or better, unless you offsetting credits or losses to take some of the bite out of the capital gains. This way, you will have a chance of reducing your overall tax bill and pocketing more of the cash.

Related Articles
  1. Mutual Funds & ETFs

    3 AllianceBernstein Funds that Are Rated 5 Stars by Morningstar

    Discover the top three mutual funds administered and managed by AllianceBernstein that have received five-star overall ratings from Morningstar.
  2. Retirement

    Is it Safe for Retirees to Invest in Technology?

    Tech stocks are volatile creatures, but there are ways even risk-adverse retirees can reap rewards from them. Here are some strategies.
  3. Mutual Funds & ETFs

    Is Morningstar’s Star System An Effective Ranking Tool? (MORN)

    Learn why Morningstar's star rating system is not always a great predictor of future performance, and why investors should not pick funds on star ratings alone.
  4. Stock Analysis

    The Top 5 Oil and Gas Stocks for 2016 (XOM, BP)

    Read detailed analyses of the top five oil and gas stocks, and learn why they may be poised to rise in 2016 after a dismal 2015.
  5. Retirement

    Roth IRAs Tutorial

    This comprehensive guide goes through what a Roth IRA is and how to set one up, contribute to it and withdraw from it.
  6. Mutual Funds & ETFs

    ETFs Can Be Safe Investments, If Used Correctly

    Learn about how ETFs can be a safe investment option if you know which funds to choose, including the basics of both indexed and leveraged ETFs.
  7. Mutual Funds & ETFs

    3 PIMCO Funds Rated 5 Stars by Morningstar

    Learn about three fixed income mutual funds managed by Pacific Investment Management Company (PIMCO) that have received five-star overall ratings from Morningstar.
  8. Mutual Funds & ETFs

    3 Invesco Funds Rated 5 Stars by Morningstar

    Learn about the top three mutual funds administered and managed by Invesco Ltd. that have received a five-star overall rating from Morningstar.
  9. Mutual Funds & ETFs

    The Top 5 Large Cap Core ETFs for 2016 (VUG, SPLV)

    Look out for these five ETFs in 2016, and learn why investors should closely watch how the Federal Reserve moves heading into the new year.
  10. Taxes

    Why People Renounce Their U.S Citizenship

    This year, the highest number of Americans ever took the irrevocable step of giving up their citizenship. Here's why.
RELATED FAQS
  1. What is a derivative?

    A derivative is a contract between two or more parties whose value is based on an agreed-upon underlying financial asset, ... Read Full Answer >>
  2. What is securitization?

    Securitization is the process of taking an illiquid asset, or group of assets, and through financial engineering, transforming ... Read Full Answer >>
  3. How do I file taxes for income from foreign sources?

    If you are a U.S. citizen or resident alien, your income (except for amounts exempt under federal law), including that which ... Read Full Answer >>
  4. Can hedge funds trade penny stocks?

    Hedge funds can trade penny stocks. In fact, hedge funds can trade in just about any type of security, including medium- ... Read Full Answer >>
  5. How liquid are Vanguard mutual funds?

    The Vanguard mutual fund family is one of the largest and most well-recognized fund family in the financial industry. Its ... Read Full Answer >>
  6. Why might landlords require renters insurance?

    Landlords can require renters insurance to lower their own liability and insurance costs. According to data from the Insurance ... Read Full Answer >>
Trading Center