Should you sell your investment property before retirement?

Investors who are thinking about selling an investment property before retirement often feel like they’re between a rock and a hard place.

Selling a rental before retirement means giving up the rental income the home has been generating over the years, along with a significant capital gains tax bill at the end of the year. But despite these potential drawbacks, some investors may still choose to sell.

In this article, we’ll discuss some of the pros and cons of selling an investment property before retirement and review some options for keeping a rental property well into retirement while minimizing tax when the investment home is sold.

Key Takeaways

There are pros and cons to selling an investment property before retirement, including being able to turn equity into cash and having to pay capital gains tax.
Selling a rental property may result in tax on both capital gains and depreciation recapture.
Strategies for reducing tax liability when selling an investment property include tax harvesting, forming an LLC, or using a real estate trust for tax planning purposes.

Things to consider when selling investment property before retirement

The decision of whether and when to sell an investment property will depend on an investor’s unique personal and financial situation.

For example, some real estate experts warn that the longer an investor hangs onto a rental property, the bigger the capital gains tax liability could be, assuming property prices keep increasing.

Of course, if an investor assumes that home prices will keep going up, the potential profit from selling could also increase the longer the property is held. So while the potential taxes may be bigger, the pay out could also be greater.

On the flip side, some investors may consider cashing out while home prices are high, in the event that the real estate market enters a normal downward cycle. Investors with a significant amount of equity in a rental property may begin thinking about selling and using that money for other things.

Here are some of the possible pros and cons to consider to help decide if selling before retirement is a good or bad move:

Pros

Free-up accrued equity by selling, then use the cash for other uses, such as buying a vacation home or adding to a retirement fund.
Eliminate ownership responsibilities such as reviewing financial reports from the property management company, worrying about potential negative cash flow, or ensuring that tax filings to the IRS are true and correct.
Have extra time to do more enjoyable things, such as traveling, beginning a hobby, or spending more time with family.

Cons

Loss of the rental income that could be used to supplement other retirement income.
FOMO – or fear of missing out – which is the anxiety that comes with selling too soon and missing out on potentially bigger profits.
Capital gains taxes and depreciation recapture tax will have to be paid when an investment property is sold.

How capital gains tax works

Real estate investors nearing retirement frequently ask whether seniors have to pay capital gains tax.

While there are plenty of senior citizen discounts available, unfortunately a discount on capital gains tax isn’t one of them. Retirees pay the same capital gains tax as younger investors do.

For buy-and-hold real estate investors who have held a rental property for several years, capital gains tax liability is arguably one of the biggest factors to consider before selling an investment property.

In addition to capital gains tax, landlords also consider the tax on depreciation recapture when selling rental property. Let’s take a look at both in the following example.

Calculating capital gains tax

According to Zillow, the value of a typical middle price tier home increased by 16.7% last year and is forecast to grow by another 12.1% this year (as of July 31, 2021).

Ten years ago, the typical home value was $164,000 and today the same home is worth $304,000. Hypothetically, if an investor purchased a typical home a decade ago and decided to sell today, the potential capital gain would be $140,000 before tax deductible closing costs ($304,000 – $164,000).

The tax on long-term capital gains is 0%, 15%, or 20%, depending on an investor’s total taxable federal income.

If an investor who is married and files returns jointly with a spouse has taxable income of $80,800 or less, the capital gains tax would be 0%. On the other hand, if that same investor has taxable income over $496,000, the capital gains tax rate would be 20%.

Based on this example, the potential capital gains tax owed would range from $0 to $28,000 ($140,000 capital gain x 20% maximum tax rate on capital gains).

Depreciation recapture tax

But the potential taxes when selling an investment property don’t stop there.

The IRS also requires an investor to recapture the depreciation expense taken during the time the rental property was owned, and pay tax of up to 25%.

Residential investment property depreciates over 27.5 years. If the investment property was purchased for $164,000 and the land value was $14,000, the total depreciation taken over the 10-year holding period would be $54,545 ($150,000 / 27.5 years x 10 years).

By multiplying the amount of depreciation expense taken by the 25% maximum tax rate on depreciation recapture, the depreciation recapture tax could be as high as $13,636..

In this hypothetical example, the maximum tax liability for selling the investment property before retirement would be $41,636 ($28,000 maximum capital gains tax + $13,636 maximum depreciation recapture tax).

For more information on capital gains and recapture tax, readers may refer to:

Options for minimizing tax liability

The example above is just for one property. The potential tax hit when selling an investment property before retirement could increase based on the number of rental homes in an investor’s portfolio, assuming every investment has increased in value over the holding period.

Fortunately, there are several options an investor has to help minimize the tax liability if a property is sold.

Wait until retirement

Retirees often fall into a lower tax bracket than they were in their working years. By waiting to sell an investment property until after retirement, the amount of tax on capital gains and depreciation recapture could decrease based on an investor’s amount of federal taxable income. By waiting to sell, an investor could collect additional income that would be lost by selling before retirement.

Offset capital gains with losses

By using a tax-harvesting strategy, an investor can offset the gains from the sale of one asset with the losses of another. For example, if an investor has stocks that are sold at a loss, the amount of the loss could be used to reduce or eliminate the taxable gain on the sale of an investment property. If losses exceed gains in a given year, an investor may carry the loss forward to later years.

Move into rental property

Another option for minimizing the tax liability of selling an investment property is to move into the rental and use it as a primary residence. However, this option can be a bit tricky. The capital gains tax exclusion will vary based on the amount of time the home was used as an investment versus a primary residence. Also, any depreciation expense claimed when the home was an investment property will still be taxed as income, when and if the home is sold.

Conduct a 1031 exchange

A 1031 tax deferred exchange is an option to consider for investors who aren’t yet ready to retire their investments. By selling one investment property and replacing it with another, investors can defer the payment of capital gains tax and depreciation recapture tax. IRS 1031 exchange rules impose strict requirements, including that a replacement property be identified within 45 days of the sale of the relinquished property, that the sale of the replacement property closes within 180 days, and that the funds be paid through a qualified intermediary.

There are two other strategies investors use to reduce potential tax liability over the long term without actually selling the investment:

Form an LLC

An investment property may be transferred into a limited liability company (LLC), with the investor, family members, or other individuals owning shares of the LLC. Each member owns an interest in the LLC, and the LLC owns the rental property. Shares can be transferred among family members, even after the investor passes away. Investors who own multiple rental properties may form an LLC for each home, then place them all under a master LLC or a real estate trust.

Transfer property to a trust

A real estate trust for rental property may allow an investor to avoid tax on capital gains and depreciation recapture, along with the costly and time consuming probate process.

After forming a living revocable trust, the real estate investments are transferred to and retitled in the name of the trust. The investor retains control of the property when alive. When the investor passes away, the trust may become irrevocable and a trustee is appointed to manage the assets in the trust for the benefit of the trust beneficiaries.

When a rental property is inherited, the property is revalued at a “step-up basis” for tax purposes. If the heirs decide to sell the inherited rental property shortly after the death of the investor/grantor, their taxable capital gain may be minimal.

Final thoughts

There are a lot of variables to consider when selling an investment property before retirement, and investors may wish to consult with a certified public accountant, tax advisor, or other licensed professional when making a decision.

The amount of equity in the property is one factor to think about, along with the amount of capital gains tax owed. Selling at the wrong phase of the real estate market cycle could mean leaving money on the table by selling when prices are still on the rise, or selling when market values are declining.

When the time is right to sell, you can market your property to a global network of real estate investors by listing through the Roofstock marketplace. Roofstock charges a transparent, fixed sales commission of only 3% or $2,500, whichever is greater. Plus, by selling on the Roofstock marketplace, you can avoid cumbersome open houses and real estate showings and work with a team that is knowledgeable about real estate investment properties.