The local real estate market has been getting stronger over the past twelve months and listed properties are taking shorter amounts of time to sell. Several of my clients have sold rental real estate properties in the past few months, so I think it would be a good time to review the taxes and tax benefits to expect.
Today, individual income taxes can come in the form of long-term capital gains tax, ordinary income tax, net investment income tax (NIIT), and alternative minimum tax (AMT). There are multiple tax rates that apply in several of these tax categories. For instance, long-term capital gains tax can be 0%, 15%, 20%, 25%, or 28%. Ordinary tax rates are 10%, 15%, 25%, 28%, 33%, 35%, and 39.6%. AMT rates are 26% and 28% and the NIIT is 3.8%.
When rental real estate is sold, the first thing to understand is the calculation of the gain. It is the gain that is subject to tax and not the sales price. So, how do we calculate the gain? Generally, the settlement statement for a real estate sale has two columns. The column on the left will include uses of the escrow funds (charges) and the column on the right will include sources of escrow funds (credit). We need to determine three amounts for the gain calculation – the sales price, the expense of sale, and the adjusted basis of the property being sold. The sales price should be found in the right hand column of the closing or settlement statement. If there are any seller contributions to the buyer’s closing costs or any allowances being given by the seller to the buyer described in the left hand column of the settlement statement those should be subtracted from the sales price to arrive at the net sales price. The expenses of sale should be listed in the left hand column and include real estate brokerage fees, escrow fees, title charges, and additional charges and credits arising from the sale. Prorations as of close of escrow are generally items that will be deductible expenses or included in income during the year of sale and should not be considered in the gain calculation. Lastly, we must determine the adjusted basis of the property. The adjusted basis will include the original cost of the land and building, plus any improvements that have been added to the depreciation schedule for the property, less the amount of depreciation claimed during the time of ownership of the property. The gain computation then involves subtracting the expenses of sale and the adjusted basis from the sales price.
Typically, the gain on sale is thought of as a capital gain and people quickly assume a tax rate of 15% since that is the most commonly discussed capital gain tax rate. However, the gain must first be analyzed to determine the appropriate capital gain tax rate. To the extent that the gain represents depreciation taken during the time of ownership, and assuming straight line depreciation, the gain is taxed at 25%. That amount of the gain is referred to as section 1250 unrecaptured gain. The remainder of the gain is taxed at 0%, 15%, or 20% depending on the tax bracket of the taxpayer with respect to his/her ordinary income for that specific tax year. Now you might understand why your CPA pauses when you ask the question about the tax rate that applies to the gain on the sale of your rental property. When your CPA starts to answer your question by saying it depends, pay close attention.
Another aspect of selling rental real estate is the unlocking of suspended losses that may have built up over the years you have owned the property being sold. If, during your years of ownership you experienced losses from your rental activity and your adjusted gross income (AGI) exceeded $150,000, you were probably not allowed to deduct the rental losses unless you had other sources of income that were passive in nature. If you do have losses from rental property that you were unable to deduct in earlier years, they will be available to deduct in the year you sell the property. Note that it must be a complete disposition of the property to free up these suspended losses, and that completing a tax deferred like-kind exchange of your rental property will not allow you to deduct the suspended losses.
These suspended losses that become deductions in the year of sale will offset your various sources of ordinary income and help to drive your ordinary tax rate down. Remember that the capital gain rate (0%, 15% or 20%) that applies to the non-recapture portion of the capital gain on the real estate sale is determined by your ordinary income tax rate.
You may also find that you have previous short-term and/or long-term capital losses that are in a carryover position. Up until now you have been permitted to use them at a rate of $3,000 per year, assuming you had no other capital gain income and may have been wondering when you will be able to more fully use these losses. These can now be used against the gain on the sale of the rental real estate, plus $3,000.
There are two more taxes that could apply in the case of selling rental real estate. The NIIT is an additional 3.8% tax on the lesser of (1) net investment income or (2) excess of modified AGI over the threshold amounts of $250,000 (married filing joint), $125,000 (married filing separate), and $200,000 (single and head of household). The gain from the sale of rental real estate will generally be considered net investment income and if your AGI is over the threshold you could be hit with the 3.8% tax on the excess or the net investment income. The AMT is a tax that can surface in many situations. It is not specifically applicable to sales of property, but just be aware that it can appear and it should be considered when tax planning is done.
As you can see, there are many taxes and many moving parts to consider when planning a sale of rental real estate. Consult your tax advisor early in the process and plan ahead for the resulting taxes and benefits.