You might think selling a piece of real estate is a simple tax situation, but you would be wrong. Many considerations need to be thought out. Not the least of which is determining the original basis and the adjusted basis at time of sale. When you know your basis you can determine if there is a gain or loss on sale. If there is a gain you may also have depreciation recapture. The worst thing that can happen though is that inadequate records were kept.
Determining the proper basis is not as easy as looking up the original purchase price. It is not uncommon that investors spend time and money in the acquisition process. You might have travel expenses related to your inspection of the property; you might have hired someone to inspect various properties for you. Many of these due diligence costs must be added to the basis of the property you purchase. When you purchase the property there are also acquisition costs paid, like a title search and recording fees. Loan related fees are not added to the basis of a property.
GAIN OR LOSS ON SALE
When you are sure of your current adjusted basis and the original basis you’ll know what your gain or loss in the property is. This is a relatively simple equation
Adjusted Basis at time of sale — minus Original Basis — minus Selling Expenses — minus Carry Forward Losses — equals Recognized Gain or Loss on Sale
Common selling expenses might be real estate commissions, repair costs to get a property ready for sale or costs of staging a home.
An investor that has needed to carry forward losses each year will finally get to use these losses when the property is sold. It is important that your rental expenses each year are properly accounted for so that they get allocated to the proper properties and nothing gets missed that can serve as a reduction in any future gain on sale.
I’m going to spend more time on this section. I know that depreciation recapture is one of the most confusing parts of the tax code and yet many investors are impacted by it at some point.
An investor who has a gain on sale doesn’t automatically get to use the capital gains rates when determining the tax. Legislation was passed many years ago now that makes it necessary to look at depreciation that was taken or should have been taken while the property was used as an investment. Because this depreciation was allowed to offset ordinary income over the years the IRS and legislators decided that it was only appropriate to look at how much of any gain night be attributable to this favorable tax treatment in the past. This step in examining the gain is called depreciation recapture.
Depreciation recapture in its simplest terms is looking at how much of any gain should be taxed at ordinary income tax rates as opposed to capital gains rates. Recapture is based on all depreciation that was allowed while a property was an investment. The key here is allowed. Some fail to realize that even if depreciation wasn’t taken at some point the IRS will continue to base a recapture on the amount of depreciation that was allowed.
Part of the confusion also comes from the different capital gains rates for buildings depreciated as real property as opposed to say rental appliances that were depreciated at more favorable personal property rates. Real property also commonly treated as section 1250 property has a capital gains rate of 25%. Real property typically is not subject to depreciation recapture because it has been depreciated using a straight line method rather than an accelerated method of depreciation. 25% for some investors though may mean that the gain was taxed at their personal ordinary income tax rate and they see no favorable tax treatment in the capital gains rate.
For any personal property related to the rental property sold their generally is some depreciation recapture because normally personal property is depreciated using MACRS which is an accelerated depreciation method. An asset that was fully depreciated then will be entirely subject to depreciation recapture and by definition then the gain will be taxed at ordinary income tax rates. An investor that purchased a new appliance during the current year will have no depreciation recapture on that asset and so will enjoy 10% capital gains treatment on this property.
GOOD RECORDS ARE ESSENTIAL
There are many expenses related to real estate some of which must be capitalized. Those that must be capitalized require a great deal more attention and must be safely kept. An investor’s records of purchase, refinance, improvements, depreciation schedules, documentation to support “in service date”, records of liens, encumbrances, etc must be maintained so that they can support the numbers used as a gain or loss. It would be a shame to have expenditures disallowed for an improvement just because no evidence of the improvement can be found.
This can be challenging because investors might hold onto a property for many years, perhaps even a lifetime. During that period records can be lost. You’ll want to do everything you can to insure these records are safeguarded.