Congratulations! You just sold your rental home and you’re ready to move on to the next chapter. You found the perfect beach view condo in Maui for $350,000 that you should just be able to afford with the cash from your house.
Do you know what you’ll have in your pocket when the deal is done? “Of course,” you say, “I just take the selling price and deduct my mortgage payoff, right?”
Your house is worth $750,000 and you owe less than $400,000. This seems simple enough.
Well, it’s not so simple. There are different taxation rules for primary residences, second residences, and rentals. In addition to income tax consequences, you need to factor in closing costs and the confusing concept called “basis.”
Rather than writing a War and Peace-length chapter explaining all these nuances, I’d like to offer one example of selling a rental house to try to shed some light on these. Ideally, you’ll speak to a good CPA before making large transactions.
Often when people are selling rental property they don’t fully understand the terms cash flow, proceeds, and taxable gains and how these relate to their bottom line.
Cash flow is the money in your pocket once the deal is done.
Gross proceeds is the full amount the buyer is willing to pay. Many people forget to subtract closing costs from this number to arrive at their net proceeds from the sale.
In addition, you must pay income tax based on your taxable gain when selling rental property, which may not be the case in a primary residence, and this tax must also be subtracted from your net proceeds before you can finally arrive at the actual amount of money in your pocket (net cash).
Basis can be a confusing concept, but is important for determining what you will be taxed on. If you purchased the property for $400,000, this is your initial basis. If you put an addition on that costs $100,000, your basis is now $500,000. Since it was a rental property, you took a depreciation deduction each year which incrementally reduced your basis figure over time.
It’s now 10 years later and you’re ready to sell. Let’s assume you took out an equity loan some years back and your remaining mortgage balance is $397,045 and the sales price is $750,000. Your taxable gain is calculated as follows:
Basis before adjustments
Less accumulated depreciation
Plus closing costs @ 8%
Less adjusted basis
However this is not the net cash that you will walk away with. Paying off a mortgage when a property is sold does not reduce your taxable gain—but it does reduce the net cash you have in your pocket. Your net cash will be:
Less remaining mortgage
Less closing costs
Less tax on gain
Net proceeds (cash in pocket)
Now you know if you can be on the beach in Maui or if you should start looking in Arizona instead.