Ask the Tax Editor, June 5: Tax Rules for Landlords

Each week in our Ask the Editor series, Joy Taylor, The Kiplinger Tax Letter editor, answers questions on topics submitted by readers. This week, she's looking at five tax questions for landlords who own residential rental property. (Get a free issue of The Kiplinger Tax Letter or subscribe.)

1. Taxes if you sell rental property

Question: I own a condo that I have been renting out to tenants for over 20 years. I plan to sell the condo this year. Will I qualify for the home sale exclusion?

Joy Taylor: Unfortunately, it doesn't sound like you will qualify for this break. Homeowners who own and use their home as their principal residence for at least two out of the five years before selling it get to exclude $250,000 of the gain when they sell. The gain exclusion is $500,000 for married couples who file a joint return.

Since you have owned the condo as rental property and not your primary residence, you would not qualify for the home sale gain exclusion. The gain or loss when you sell would generally be characterized as capital gain or loss. And, since you owned the condo for more than one year, it's considered a long-term capital gain or loss.

The capital gain will generally be taxed at 0%, 15%, or 20% — plus the 3.8% net investment income tax (NIIT) for people with higher incomes. However, a special rule applies to gain on the sale of rental property for which you took depreciation deductions.

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When depreciable real property held for more than one year is sold at a gain, the federal tax law requires that previously deducted depreciation be recaptured into income and taxed at a top rate of 25%. This is known as unrecaptured Section 1250 gain, the number of its federal tax code section.

2. Inheriting rental property and taxes

Question: I own rental property. When I die, I plan to leave it to my child. Does he get a step up in basis in the property upon my death? Also, what happens to the depreciation that I had previously deducted on the property?

Joy Taylor: The answer to your first question is yes, your beneficiary would take a stepped-up tax basis in the rental property when you die. That means your child's basis in the inherited property would be its fair market value on the date of your death.

I haven't looked at the depreciation issue before, but it is my impression that your depreciation essentially disappears when you die. Again, your beneficiary takes a stepped-up tax basis in the property. If he decides to keep renting the property, he would depreciate it over 27.5 years, beginning in the year he inherited it and using the stepped-up tax basis.

3. The net investment income tax for landlords

Question: I own a triplex, and I rent out all three apartments in the building. I am thinking of selling the property in the next year or so. I know I will pay capital gains tax on the sale. Will I also have to pay the 3.8% net investment income tax?

Joy Taylor: Maybe. The additional 3.8% net investment income (NII) tax applies to single filers with modified adjusted gross income (AGI) over $200,000 and to joint filers with modified AGI above $250,000. The modified AGI threshold is $125,000 for married people filing separate tax returns. These modified AGI amounts aren’t inflation-indexed, leading to more filers paying the NII tax each year.

The NII tax, which is added to the regular income tax, is due on the smaller of NII or the excess of modified AGI over the threshold amounts. NII includes dividends, capital gains, taxable interest, annuities, royalties, passive rents and certain income from other passive activities.

4. Selling a rental that you previously lived in

Question: I own a home that I lived in from 2014 to 2017. I then married and moved into my wife's new home. I rented out my old home from 2017 until now. I plan to sell it this year. How do I establish my tax basis for purposes of determining gain or loss when I sell?

Joy Taylor: Your tax basis in the rental home is as follows: (1) the lesser of your original cost or fair market value of the home at the time you started renting it, plus (2) the cost of improvements to the home, less (3) depreciation taken on the home. IRS Publication 544, Sales and Other Dispositions of Assets, has more information.

5. Selling a duplex

Question: My wife and I own a duplex. We live in the upstairs unit, and a tenant lives in the downstairs unit. The upstairs and downstairs units each have separate addresses. We are now considering selling the full duplex. Can we take the full $500,000 home-sale exclusion when we sell?

Joy Taylor: The up-to-$500,000 gain exclusion applies only to the portion of your duplex that you used for residential purposes (not rental or business purposes). Below is relevant language from IRS Publication 523, Selling Your Home:

"You generally can’t exclude gain on the separate portion of your property used for business or to produce rental income. Examples are: (1) a working farm on which your house was located, (2) a duplex in which you lived in one unit and rented the other, or (3) a store building with an upstairs apartment in which you lived."

"[A]n allocation of the gain is required. For this purpose, you must allocate the basis of the property and the amount realized between the residential and nonresidential portions of the property using the same method of allocation that you used to determine depreciation adjustments. Report the sale of the business or rental part on [IRS] Form 4797."

About Ask the Editor, Tax Edition

Subscribers of The Kiplinger Tax Letter, The Kiplinger Letter and The Kiplinger Retirement Report can ask Joy questions about tax topics. You'll find full details of how to submit questions in each publication. Subscribe to The Kiplinger Tax Letter, The Kiplinger Letter or The Kiplinger Retirement Report.

We have already received many questions from readers on topics related to tax changes in the One Big Beautiful Bill, retirement accounts and more. We will continue to answer these in future Ask the Editor roundups. So keep those questions coming!

More Reader Questions Answered

• All Ask the Editor Q&As
• Ask the Editor: Will I be Audited by the IRS?
• Ask the Editor: Questions on Residential Rental Property
• Ask the Editor: 10-Year Rule for Inherited IRAs
• Ask the Editor: Tax Questions on Roth IRA Conversions
• Ask the Editor: Reader Questions on QCDs