A capital gain is the taxable profit you make when you sell your rental property and as such constitutes somewhat of a paradox. The fact that you have a capital gains indicates that you made a profit on your rental property investment (good news) and yet are now obligated to pay taxes on that profit (bad news),

In this article, we’ll look at capital gains and show you how to compute it in a simple, straightforward way so you get the idea. Obviously, not unlike any tax issue, it is always best to consult a tax expert before you buy or sell any rental properties.

What is a Capital Gain?

As stated, capital gains are the profit a real estate investor makes on an investment property held for more than 12 months and is taxable once that property is sold.

Okay, but computing capital gains is not as simple as say, buying a property for $200,000, selling it for $250,000, and expecting a gain of $50,000. A gain is the difference between a property’s “net selling price” and its “adjusted basis” and is not computed by merely deducting the price you originally paid for a property from the price it is eventually sold.

Computing the Net Selling Price

The net selling price is computed by taking the price that your rental property is sold for less the costs associated with the sale. Say that you sell your property for $579,000 and pay a 6% real estate commission then your net selling price would be $579,000 - 34,740, or $544,260.

Computing the Adjusted Basis

The adjusted basis is computed by taking the original cost of the property, plus the cost of acquisition and capital improvements, less accumulated depreciation.

Say, for example, that you originally purchased an apartment building for $500,000, paid closing costs of $5,000, made capital additions of $20,000, and have taken $66,000 in depreciation. Your property’s adjusted basis at sale is $500,000 + 5,000 + 20,000 – 65,906, or $459,904.

Computing the Gain

Okay, now that we know the net selling price ($544,260) and the adjusted basis ($459,904) we can compute the capital gain by taking the difference, $544,260 – 459,904, or $85,166.

Long Term Gain vs. Short Term Gain

In conclusion, I should mention that the IRS sets the rate at which the gain is taxed depending on whether the gain is short term or long term.

Under the current tax code, if you hold a property for less than 12 months and sell for a profit, the gain is classified as short term and treated as ordinary income. If you hold it 12 months or longer then the gain is classified as a long-term capital gain. The difference to you can easily amount to thousands of dollars because current rules tax capital gains at a lower rate than ordinary income. So consider timing before you decide to sell a rental property and remember to consult your tax advisor.