Owning a rental property has tax consequences, both while you are operating it and when you sell it. Tracking all income, expenses and improvements is necessary to calculate the correct gain or loss you may have when you sell the property or transfer it. Gains or losses on the sale of this type of property are different than when you sell your primary residence.
Rental Property Basics
When you own a rental property, you will receive rental income and pay the expenses associated with managing and repairing the property, including property taxes and mortgage payments. In some years, you may make a net profit, but in some, there may be net losses because of major repairs or other expenses. Because rental income is considered passive income, you are restricted in the amount of loss you can claim in a year. Any loss above that amount can be carried over to the next year. When you sell the property, you calculate the gain by subtracting the adjusted cost base of the house from the net sales price.
Calculating the Adjusted Cost Base
The adjusted cost base of the rental property includes more than just what it cost. For tax purposes, the cost is the purchase price plus all costs and fees involved with the purchase, such as title and escrow fees. Also include any improvements to the property in the time you have owned it, such as a roof replacement or upgraded windows. Add in all of the costs of selling the property, including realtor and legal fees. Finally, subtract the total accumulated depreciation that you have claimed for tax purposes during the time you owned the property. The resulting figure is the adjusted cost base of the property for tax purposes.
Calculating the Gain or Loss on Sale
Subtract the adjusted cost base of the property from the sales price to calculate your overall gain or loss on the property. If there is a gain, it must be split into two parts: recaptured depreciation and taxable capital gain. The recaptured depreciation is taxed as regular income because the deduction was taken at that rate. The net capital gain has preferential tax treatment and will be taxed at a lesser rate.
Reporting Gains and Losses on Rental Property
Gains and losses on the sale of a rental property by an individual taxpayer are reported on Schedule D of the 1040 return. You must also fill out Form 4797 to report the details of the sale. For example, assume you bought a rental property five years ago for $90,000, including costs. You also spent $5,000 of improvements on it, it depreciated $3,150 over the five years, and you then sold it for $107,000 with sales costs of $4,700. In this example, the adjusted cost base of the property would be $90,000 plus $5,000 plus $4,700 minus $3,150, which equals $96,550. The total gain would be $10,450, and $3,150 of that amount is claimed as recaptured depreciation, while the other $7,300 is a taxable capital gain claimed on Schedule D.
- IRS.gov: Publication 544 (2010), Sales and Other Dispositions of Assets
- IRS.gov: Publication 527 (2010), Residential Rental Property
- IRS.gov: 2010 Instructions for Schedule E (Form 1040)
- Internal Revenue Service. "Tips on Rental Real Estate Income, Deductions and Recordkeeping." Accessed Sept. 30, 2019.
- Internal Revenue Service. "Publication 946, How to Depreciate Property." Accessed Sept. 30, 2019.
- Internal Revenue Service. "Publication 551, Basis of Assets." Accessed March 16, 2020.
- Internal Revenue Service. "Publication 527, Residential Rental Property." Accessed March 16, 2020.
Angie Mohr is a syndicated finance columnist who has been writing professionally since 1987. She is the author of the bestselling "Numbers 101 for Small Business" books and "Piggy Banks to Paychecks: Helping Kids Understand the Value of a Dollar." She is a chartered accountant, certified management accountant and certified public accountant with a Bachelor of Arts in economics from Wilfrid Laurier University.