Capital Gains Lessons Learned

A couple of months ago, we sold our first rental property. It was a nice 2BR/2BA condo unit that served us well as a solid investment for seven years. We sold the property at a nice profit and overall came out well on the deal. I shared our initial observations about selling, just a few weeks ago.  

I’d like to take a minute to drill down on the lessons we learned about capital gains tax. While I’ve paid capital gains on other investments in years past, this was our first experience with gains tax from the sale of a capital asset. To be clear, these are more lessons accepted, rather than learned. Taxes are inevitable, like death!

That being said, there were three big take aways from our experience that I’ll consider more thoroughly prior to our next disposition of a capital asset.

Don’t forget about depreciation recapture and state capital gains tax. We understood clearly the 15% tax (for most earners) on the net gain from the sale of a capital asset. What we didn’t think through clearly enough was the 25% tax on previous years depreciation and 5% state capital gains tax! Regarding the depreciation recapture, we were fortunate that the basis on this particular investment was very low and we only depreciated it for seven tax years.

I think the so what to considering the depreciation recapture is to plan for it when considering how long to hold an investment. If basis for the asset is high and straight line depreciated for the max allowable 27.5 years, then the investor could be looking at a fairly substantial recapture bill. Don’t get me wrong, I am still a huge fan of the here and now tax benefits of depreciation on real estate investments, but recapture requires the investor to think about how much of that depreciation they will inevitably have to give back some day!

I am embarrassed to say, I didn’t even know our state had a capital gains tax of 5%. I learned about two weeks before closing when making calculations on our tax bill. This means our effective capital gains tax was 20% with state and federal combined. When considering selling an asset, definitely find out about state capital gains tax and plan for it!

Consider mitigation strategies.   I use the word “consider” because mitigation strategies are dependent on the investors reason / need to sell. For us, the market was in a good spot and we planned to reallocate the equity from the asset into other investments, specifically a larger down payment on a new home, kids 529 plans and our traditional IRAs. Everyone’s reason for selling is different, but there are some mitigations to consider before selling a capital asset.

Probably the most popular capital gains mitigation strategy is a 1031 exchange where the net gain is rolled into a like kind investment. Simply put, we could have used the gain to buy a beach / mountain condo that we rented out a majority of the time, and delayed our tax bill while having some access to a vacation home.

Another mitigation strategy, if there is not a compelling need to sell, is the asset could be passed on to heirs. Currently our tax laws are such that heirs don’t inherit the basis which would make their tax bill substantially less if they chose to sell the asset. There is talk within the government of ending what many call the depreciation loophole, but something to consider. Definitely talk to a tax advisor!

Lastly, I learned as we prepared to sell this asset that those who are married filing jointly with a taxable income of $89,250, don’t have to pay capital gains tax! While this mitigation strategy might take some serious maneuvering, it would be a good one to consider for an investor whose station in life may be pre fixed income and post wage earner. Think, taking a couple of “gap years” between your last day working and starting to draw pensions, retirement or social security benefits in order to shuck some real estate investments. Those gap years could be a good time to sell! Worth a look, but as previously stated best to consult a professional.

Seek help from a licensed professional. Like most things, I did this whole operation myself. After some self-study and finding one of the many on line capital gains calculators that I liked, I calculated our bill. Capital gains should be paid in the quarter when the gain was taken, so I sent in our payment via the IRS online payment system in June, a few weeks after closing. I am fairly confident I calculated correctly, but the real proof will be when we file our 2023 taxes next year. I am fearful I may have overlooked some required forms or made a simple accounting error. To alleviate this anxiety, just hire a professional.  While they too may make mistakes, you can at least have some recourse!

Our recent experience with paying capital gains tax caused us to reevaluate some of our financial plans regarding the disposition of our real estate. Originally, we had planned to convert our current home into a rental upon moving into a new home. After increasing our understanding of capital gains, we realize we’d have to hold the property for probably longer than we want in order to break even on the inevitable tax burden. Better to sell now while considered a primary residence and avoid capital gains (another mitigation strategy by the way).

I’ve lamented previously about the mystery that is federal income taxes. While taxes remain a mystery, this experience made us a little wiser. Not looking forward to it, but at least better prepared to pay capital gains tax when we make our next real estate sale!

Looking for a good how-to on wealth building? Check out my book, Millionaire on a Worker’s Budget: Five Financial Truth’s to Build Wealth on sale now at Amazon!

Interested in rental property investing? Look for “Collect Rent, Don’t Pay It: A Beginner’s Guide to Rental Property Investing” on Amazon to learn how our family turned rental property investing into a successful side hustle!

The commentary provided in this blog is for informational purposes only and is not intended to be a source of financial or investing advice.

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