When selling a rental property, it’s essential to understand how capital gains are calculated. Capital gains refer to the profit made from selling an asset, such as real estate, for more than its original purchase price. In this article, we’ll discuss how capital gains are calculated on the sale of rental property and what factors can impact these calculations.

1. Calculate the Adjusted Cost Basis

The adjusted cost basis of a rental property is its original purchase price, plus any improvements made and major repairs, minus any depreciation claimed over the years. To arrive at this number:

a. Start with the initial purchase price.

b. Add any closing costs or fees associated with buying the property (excluding financing costs).

c. Add the cost of any improvements or major repairs made during ownership.

d. Subtract any depreciation claimed over the years.

This will give you the adjusted cost basis of your rental property.

2. Determine the Net Selling Price

The net selling price is the amount received from the sale of your rental property, minus any closing costs or fees associated with selling it. To find the net selling price:

a. Take the total revenue from selling the property.

b. Subtract any closing costs or fees related to selling it (e.g., real estate agent fees).

3. Calculate Capital Gains

To calculate your capital gains, simply subtract your adjusted cost basis from your net selling price:

Capital Gains = Net Selling Price – Adjusted Cost Basis

4. Determine Tax Rates

The tax rate applied to your capital gain depends on whether it’s classified as a short-term or long-term gain:

a. Short-Term Capital Gain: If you owned the property for one year or less before selling, your gain is considered short-term and is taxed at your regular income tax rate.

b. Long-Term Capital Gain: If you owned the property for more than one year, your gain is considered long-term and is taxed at a more favorable rate, which varies depending on your income.

5. Impact of Depreciation Recapture

When selling rental property, you’ll also need to consider depreciation recapture. This refers to the portion of your capital gain that must be reported as ordinary income when selling the property due to claiming depreciation over the years. The maximum tax rate for depreciation recapture is currently 25%.

In conclusion, calculating capital gains tax on the sale of rental property involves determining your adjusted cost basis, net selling price, and the type of capital gains (short-term or long-term). It’s essential to consult with a tax professional to ensure accurate calculations and understand the impact of depreciation recapture on your tax liability.