The federal tax law provides minimal exceptions to the rule that taxpayers must pay capital gains tax when they recognize a profit or gain on the sale of an asset. Unless you meet one of the narrow exceptions, you must pay tax in the year you sell a rental property at a profit.
The federal tax law classifies the purchase or sale of an asset you acquire for investment or personal use purposes as a capital asset transaction. Sales and exchanges of a capital asset require you to pay gain on the transaction using capital gains tax rates. When you purchase a rental property with the intent of generating income, it is an investment asset subject to capitalization. This requires you to calculate the property’s tax basis. The basis includes the purchase price plus any cost you incur to complete the transaction. You must increase the tax basis for any permanent improvements you make to the rental property that either increase its value or prolong its useful life.
The Internal Revenue Code allows you to defer a taxable gain on property if you exchange it for the same type of property or sell the property and purchase similar property within 180 days of selling the old property. However, if you sell a rental property and purchase a personal residence, you cannot defer the gain on the sale of the rental property. To qualify, the new property you receive must not only be real estate, but you must hold it for the same purpose. Transferring an investment property for personal-use property does not qualify as like-kind. If you purchase another rental property rather than a personal residence, you can take advantage of the gain deferral.
If you choose to use the proceeds of the rental property sale to purchase a personal residence, you must calculate the gain on the sale transaction. You calculate gain by subtracting from the gross proceeds of the sale the tax basis in the rental property. In addition to cash, gross proceeds include the value of any services or property you receive in exchange for the rental property. The later purchase of the personal residence has no affect on the sale of the rental property.
The IRS requires you to report all gains resulting from capital asset transactions on the Schedule D attachment to IRS Form 1040. Any capital losses that you incur in the current year, or are able to carry forward from a previous year, can reduce the amount of profit that is subject to the capital gains tax. If you determine that you qualify for the like-kind exchange, the IRS requires you to provide full details of the transaction on IRS Form 8824 and attach it to the current year’s tax return.