Planning to Sell a Rental? Three Tax Moves Owners Should Consider

KEVIN FOROOTAN, CPA/CGMA
Managing Partner
MyCPA, LLP
mycpallp.com

For many California real estate investors, selling a rental property can mark the end of years of ownership, appreciation, and equity growth. But a sale that looks profitable on paper can also lead to a sizable tax bill.

As property values have climbed over time, owners may be exposed to federal capital gains tax, tax tied to prior depreciation deductions, California income tax, and possibly the 3.8% net investment income tax.

The encouraging part is that owners have choices. Knowing three different approaches before a sale can have a major impact on long-term finances.

OPTION 1: SELL THE PROPERTY AND PAY THE TAXES

In some situations, the most direct approach is the right one.

An outright sale gives owners cash immediately and maximum flexibility. The proceeds can be used for retirement, investment diversification, debt reduction, or other goals without the limits that come with owning real estate.

Still, the real tax cost should be understood in advance. For example, an investor who bought a rental for $500,000 and later sold it for $1.5 million may appear to have a $1 million gain. But depreciation taken over the years can lower the property's adjusted tax basis, which may increase the amount subject to tax.

California also taxes capital gains at ordinary state income tax rates, which can make the total burden especially heavy. Before selling, owners should ask for a full tax projection that accounts for adjusted basis, depreciation, selling costs, capital gains, and any planning opportunities that may still be available.

OPTION 2: DEFER TAXES THROUGH A TRADITIONAL 1031 EXCHANGE

For investors who want to stay in real estate, a Section 1031 exchange can defer taxable gains by rolling proceeds into qualifying replacement investment property.

This strategy can preserve capital that otherwise would go toward immediate taxes, potentially giving the investor more buying power.

But the deadlines are strict. In general, replacement properties must be identified within 45 days, and the exchange must be completed within 180 days after the original property is transferred, or sooner if a tax filing deadline applies.

A qualified intermediary should be in place before the sale closes.

Traditional exchanges may allow investors to buy larger properties, improve cash flow, spread investments across different regions, or consolidate holdings. Even so, a 1031 exchange typically defers taxes rather than erasing them. Taking cash or certain other benefits can also create partial taxation.

OPTION 3: MOVE INTO PASSIVE REAL ESTATE THROUGH A DELAWARE STATUTORY TRUST

What if an owner wants to step away from tenant calls, repairs, vacancies, and maintenance without immediately triggering a large tax bill?

A Delaware Statutory Trust, or DST, may provide one path. Under qualifying structures, investors can exchange appreciated real estate for beneficial interests in a DST that holds professionally managed property.

The investor generally becomes passive and may receive distributions when available, without handling day-to-day management.

For long-time landlords nearing retirement, this can be a way to keep exposure to real estate while reducing management duties.

That said, DSTs carry risks, including limited liquidity, less control, management fees, uncertain distributions, and the possibility of losing principal.

Not every DST qualifies for Section 1031 treatment, so careful structuring and due diligence are essential.

THE MOST IMPORTANT DECISION COMES BEFORE THE SALE

The biggest mistake many real estate owners make is waiting until a deal is almost finished before reviewing tax options.

By that point, some valuable planning moves may no longer be available. Whether the goal is liquidity, continued active ownership, or passive income, each option serves a different financial purpose.

Before selling appreciated real estate, investors should work with their CPA, real estate professionals, and appropriate investment advisors to weigh the tax consequences and long-term objectives.

In the end, the key question is not just, “How much can I sell my property for?” It is, “How much will I keep, and how can I put that wealth to work?”