How To Avoid Tax Penalty When Selling A Rental Property

[Ben T.]

Hello - I will send a rental property this year. LT gain expected of about $200k. My wife and I are above $150k AGI. 

Can one please explain to me how to avoid underpayment penalty? I am confused with “quarterly estimated payments”. Wife and I are on W2. Do estimated payments apply to me ie have to make those quarterly? 

Just explanation of what I need to do will help. 

[Michael Plaks]

Quote from @Ben T.:

Hello - I will send a rental property this year. LT gain expected of about $200k. My wife and I are above $150k AGI. Can one please explain to me how to avoid underpayment penalty? 

First, we have to assume that you will have a significant taxable capital gain and will NOT be using tax strategies that defer this tax, such as the already mentioned 1031 exchange. If you're not familiar with it, search Bigger Pockets, there's ton of information.

Second, the easiest thing to do is this. Look at your 2023 tax return and see how much was your total tax for 2023, line 24 of Form 1040. Let's say it was $20,000 for 2023. You take 110% of it which is $22,000.

Now, your goal is to have $22,000 withheld from your and your wife's W2s, combined. You can look at your most recent paystubs, take the YTD (year-to-date) withholdings and then prorate it for the rest of 2024. Suppose your calculation shows that you're on track to have $21,000 withheld from your paychecks in 2024.

This is $1,000 short of your goal of $22,000. Then either you or your wife, does not matter who, go to your accounting/payroll department and tell them: I need an extra $1,000 withheld from my paychecks between now and the end of the year. They will have you complete a new W4 form and then do the rest.

After that, you can forget about the underpayment penalty, Form 2210 and other complexities. You will still have to write a check to the IRS next April as you will come short of the total tax due, but without penalties.

Now, if you want to avoid having to write a check to the IRS next April, you have at least two options:
A. prepay the expected tax from your paychecks
B. implement one of the tax strategies that delay this tax
Both options require professional assistance.