Capital Gains Tax on Rental Property Sale

Dear Tax Talk,

My family income from the W-2 is only $70,000 for a family of four. However, I have a rental that I kept for five years and now have a capital gain of $500,000. Please let me know whether I would have to pay capital gains tax on the rental property and how much (or the percentage). Thank you.

-Rose

Dear Rose,

The capital gain rate is 20%, but to the extent you claimed depreciation on this rental property, some of your profits may be taxed at ordinary income tax rates.

Your gain is going to be the difference between your sales proceeds and your adjusted basis in the property. You will be able to deduct selling expenses, including commissions paid on the sale. Your adjusted basis is calculated from when you acquired the property, adding in any capital improvements and deducting the depreciation claimed on the property. The depreciation you have claimed over the past five years is subject to "recapture rules," which means you report some of the gain when you sell the property at ordinary income tax rates and some of the gain at capital gain tax rates.

What is depreciation?

Depreciation is an income tax deduction that enables taxpayers to recover the cost of certain property, including rental property. The annual allowance accounts for "wear and tear" of property.

Using the Modified Accelerated Cost Recovery System, or MACRS, residential rental property can be depreciated over 27.5 years under the general depreciation system or over 40 years using the alternative depreciation system.

Claiming depreciation isn't optional. Even if you didn't claim depreciation, it is subject to recapture when you sell the property.

Additionally, Uncle Sam has a new tax called the net investment income tax, so be prepared as it may affect you. The tax is 3.8% if you have net investment income and also have modified adjusted gross income above your threshold amount. For married filing joint returns, that amount is $250,000; for married filing separately, it is $125,000; for single and head of household filers, it is $200,000; and for qualifying widow(er) with a dependent child, it is $250,000.

Congratulations on making such a wise investment. Due to the large amount of your gain, I would recommend that you seek professional assistance in making sure your tax liability is calculated correctly.

Thanks for the great question and all the best to you.

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