Understanding How Capital Gains Are Calculated On Rental Property
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Many people enjoy the tax advantages of real estate investment and like the annual depreciation credit. When they sell the property, this depreciated value can establish the amount of capital gains tax they might have to pay, however. Of course, if you have made any improvements to the property, you can write off many of those expenses, but essentially, the capital gain is the difference between the price you sell the property for and the depreciated value plus any improvement costs.
Since homes that are held for a long term will be depreciated more, you can see how the capital gains can grow each year. Depending on the original price of the home, the depreciation credit can mean a big difference on your income taxes each year and many property investors use this to shelter the taxes they owe on income made.
Where the tables can turn is when there is a large capital gain realized between the price the investment property sold for and the depreciated cost. Since the depreciation is deducted each year from the original purchase price, each year lowers the effective cost of the property, making the profit much larger than actual cash spent.
When you are selling an investment property, there are ways to avoid the capital gains tax by investing in an equal or more expensive “like kind” investment property. Many property investors don’t worry about the capital gains tax as long as they are coming out ahead and plan to re-invest to make more profit. You can snowball your capital gains this way and as long as you continue to own investment property and purchase investment property that is equal in price or more expensive than the property you sold.
There are cases where you need to talk with a tax accountant or attorney about the best practices to use, the more involved in investment property you get. Capital gains taxes should be looked at as a deferred income tax that you are getting in exchange for the depreciation tax credits you have been able to take through the life of the asset or investment property. Many people forget that capital gains taxes should not be viewed as anything but a way to pay back those tax credits, when you realize the actual cash profits.
The problem is that the depreciated cost may show that you make a large profit on paper, when you might not make anything on the actual cost of the investment property, especially in a down market, where you can’t sell the property for what you paid and cases where the rents weren’t able to provide a positive cash flow. There are many things to consider when you invest in property for investment or rental purposes, but rental property has been an income opportunity for many average families across America for a number of years.
In markets where you can get a great deal on lower cost homes that can be used for rental property, it can still be worthwhile to make a profit, make additional cash flow and enjoy the depreciation tax credit, even though you might have capital gains taxes at a later time.
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