Calculating Taxes on a Real Estate Sale
Originally published on April 16, 2021
Updated on August 16th, 2022
If you’re a real estate professional, taxes affect just about every aspect of what you do—including property sales and purchases. Yet we’ve found many of these hard-working pros don’t have a tax plan.
In a recent installment of our Real Estate Industry Update video series, JMCo partner John VanDuzer chatted with manager Kyle Paxton about calculating the taxes on a real estate sale. The process can be divided into a few stages.
Calculating Your Gain
Before you can figure out your actual taxes on a sale, you must first calculate your gain. So Paxton started with an explanation of the formula, which is as follows:
Gain on sale
“You start with the gross proceeds on the sale of your parcel of real estate,” said Paxton, “and that’s normally the top line sales price that you agreed to for the sale. And then you adjust that gross proceeds with closing costs.” These include title costs, deed recording costs, your agent commissions, etc. However, you do not count any debt in this calculation.
Once you know your net proceeds, deduct the adjusted cost basis in the property. “The adjusted cost basis is an accounting term; it’s your original cost basis in the property,” Paxton explained. “So if you purchased it 10 years ago, it’s your initial purchase price back then, adjusted for any significant improvements you’ve made to that property while you’ve held it. Then the amount of depreciation expense… over the course of while you held that property.”
A Different Kind of Bucket List
Now that you know the gain on your sale, you can work on the tax picture. And sometimes, the answer isn’t terribly straightforward. There are multiple buckets of taxation to consider.
“The first bucket I’m going to touch on is called 1245 recapture,” said Paxton, referring to the code section that governs how this bucket works. In the most basic terms, the IRS is recovering that depreciation that you’ve deducted previously while you held that property. “You received an ordinary tax deduction for depreciation taken during the years you held the property. Now, the IRS says, ‘Okay, we’re going to tax that piece of gain to recapture that depreciation piece at ordinary rates as well.’”
The 1245 recapture only applies to depreciation taxation on personal property. This is generally the 5 and 7 year property on your depreciation schedule.
The actual real property (building and land) will be taxed at capital gain rates. At this point, you need to consider the unrecaptured 1250 gain. “On the real property piece, it takes the amount of depreciation you’ve taken back up to the original cost basis,” Paxton said. “That portion of it is going to be taxed at capital gains rates that are treated a little bit differently. It’s at a maximum of 25%.”
The remaining amount is known as 1231 gain. In most cases, this is also taxed at capital gains rates of up to 20%. “For land, you don’t get a depreciation deduction on that piece,” said Paxton. “So any portion of the sales price that’s allocated to land, and proceeds allocated to real property in excess of 1250 gains, are going to be taxed as 1231 gain.”
While the 1231 gain bucket is complicated, VanDuzer explained it can be a boon for real estate investors. “If you have a net 1231 gain, it’s taxed as capital gains, and then if you have a net 1231 loss, it’s an ordinary loss,” he said. “So it’s a very favorable code section, but basically that is the catch-all for any gains beyond that 1245 recapture and that unrecaptured 1250 gain.”
Once you have those three buckets understood and laid out, other nuances to the sale can have tax consequences. VanDuzer used an example to explain the effect of purchase price allocations.
“If you own a multi-family apartment complex and you pay a thousand dollars for a fridge, and then 10 years later you sell that fridge, you need to start thinking, ‘Is it fair that the fridge was still worth a thousand dollars?’ Or has the value has gone down over time, and maybe I could justify having a lower allocation to that piece of property?’” he explained. “And therefore it would have a lower 1245 recapture on that property because it’s really not worth what you originally paid for it.”
You also need to take into account other 1231 sales transactions that you have had. If you take an ordinary loss under 1231, and in the next five years you have a 1231 gain, it will be ordinary gain instead of capital gain.
The net investment income tax also plays a role in the tax picture of a real estate sale. “If you’re passive and your income exceeds certain thresholds, adds a 3.8% tax on top of your capital gains. So instead of it being 20% capital gains, it would be 23.8%,” said VanDuzer. If you’re a materially participating real estate professional, however, capital gains on the sale of real estate are not assessed net investment income.
Finally, if you are a passive investor, passive activity rules can apply. For example, suspended losses on a property are released when you ultimately sell. So while you may have capital gain from the sale, you also potentially could have an ordinary loss to help offset some of your other income.
As you can see, calculating your taxes on a real estate sale isn’t necessarily a cut-and-dry process. It’s one of the many reasons why working with a real estate CPA is so important. Without expertise in these matters, you could miss an important tax obligation—or lose out on extra benefits.
All content provided in this article is for informational purposes only. Matters discussed in this article are subject to change. For up-to-date information on this subject please contact a James Moore professional. James Moore will not be held responsible for any claim, loss, damage or inconvenience caused as a result of any information within these pages or any information accessed through this site.
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