Q: My wife and I are about to sell a Chicago rental property we purchased together. The house was our first home, and we moved out about seven years ago.
How can we avoid paying taxes on these proceeds? Would that be a function of our adjusted cost basis on the property?
A: You’ve got quite a bit packed into a short question. From what you’ve told us, we have no way of knowing if you have made a profit on the sale, and that’s key to figuring out how to move forward.
In simple terms, you must figure out your cost basis: what you spent to buy the house, what you spent on things the IRS would consider to be part of the house and the costs of selling it. Subtract these figures from sale price to figure out if you have made or lost money.
In much of the country, real estate values have grown since the Great Recession. However, property values in Chicago haven't done much; some properties are worth what they were 20 years ago.
If you've lost money on the sale, you may have no income taxes to pay even though you end up with cash at closing. On the other hand, if you figure out that you have a profit, you'll have a complicated time figuring out what your tax situation is. As a rental property owner, you probably took depreciation on the home and received a benefit on your federal income taxes. If you have to repay that depreciation, you'll pay a tax of around 25 percent on the recaptured amount.
Here's how it works: Let's say you took $40,000 in depreciation over the time you owned the home. In this situation, you might owe $10,000 in depreciation recapture. And if you have a profit of $50,000 on the sale of the home, you'll probably pay up to 20 percent in capital gains taxes on that profit or about $10,000 plus some other lesser taxes.
Note: We've oversimplified the possible tax situation you might face, but in this scenario you'd owe around $20,000 in federal taxes plus perhaps a couple thousand dollars in state taxes. The only way we know that you can efficiently and effectively defer paying taxes on the sale of the property is by using a 1031 exchange.
In the simplest terms, a 1031 exchange allows you to sell your property, deposit all proceeds of the sale with a 1031 exchange company (a.k.a. a 1031 exchange intermediary), then find a replacement property within 45 days of the sale, and then close on that property you found no later than 180 days after the date of the closing of the rental property you currently own.
While you might find some permutation of the 1031 exchange that allows you to sell your home and then find a replacement property, do some rehab on that property and later own that same property, we wonder if such an option would be too costly given the amount of profit you're expecting on the sale of the home.
If wish to avoid any sort of tax bill, you'd better figure out what your cost basis looks like. If your tax exposure is quite small, you might be fine cashing out and using the money to invest into other properties. On the other hand, if your tax exposure is great, you should speak with a qualified tax professional to help you figure out a plan of action well before you list the home for sale.
Ilyce Glink is the author of “100 Questions Every First-Time Home Buyer Should Ask” (4th Edition). She is also the CEO of Best Money Moves, an app that employers provide to employees to measure and dial down financial stress. Samuel J. Tamkin is a Chicago-based real estate attorney. Contact them through her website, ThinkGlink.com.