Capital Gains - Simplified

10 Replies

Hey BP,

I'm having a hard time visualizing the taxable capital gains on the backside of owning a property.

Here's an example to help simplify my question:

What gets taxed when you sell a property?

Lets assume the property was bought for 100K and financed at @ 80%.  You've enjoyed the depreciation tax benefits for 10 years, but now you're ready to sell it.

You sell the property for 150K and the loan payoff is 50K, leaving a simple 100K difference.

What is the total taxable amount from the sale, assuming standard depreciation was used?

Thank you for your time.

-Sam

I could be oversimplifying (or even "wrong"!) but here goes.

The loan does not come into play. If you buy 100k property, and sell it for 150k, your gain is 50k (I'm leaving out closing costs on both ends for simplicity). If you sell it within one year of buying, it's a "short term" gain which is taxed as ordinary income vs. capital gains rate. 

When you sell, you have to "pay back" the IRS for letting you write off depreciation. This is called "recapture". So if you've written off 30k in depreciation, you'll now have a 50k capital gain and a 30k depreciation recapture, which is taxed as ordinary income.  

If you sell using seller financing, I believe you get to split the gain up over the life of the loan. 

I'm sure more qualified folks will chime in here soon.  

Agreed with Kenneth, except the recapture is currently taxed at a straight 25%.  Your depreciation works out to about 3%/year.  Think of the depreciation deduction as basically an interest free loan, a little better or worse depending on your tax rate while it's deducted.

I'll repeat @Kenneth LaVoie 's statement the loan doesn't come into play.  However, interest on a loan is a deductible expense.  That includes points, and those may come into play for calculating taxes in some situations.  But the loan balance doesn't affect the taxes owed. Its entirely possible to buy, refi, and sell and end up bring cash to the closing table to sell and STILL have a tax bill.

Here's the details of the calculation. I'm making the usual assumption that the value of the improvements are 80% of the price you paid.  There are better ways to compute this.  Closing costs on both the sale and purchase also factor into the calculation.

1) purchase price plus your closing costs is your initial basis.

purchase price $100,000.00

purchase costs $2,000.00

initial basis $102,000.00

2) depreciation reduces your basis

value of improvements $80,000.00

annual depreciation $2,909.09

depreciation after 10 years $29,090.91

basis after 10 years $72,909.09

3) closing costs on the sale reduce your net return from the sale

selling price $150,000.00

selling costs $3,000.00

net selling price $147,000.00

4) net selling price less your basis is the total gain

total gain $74,090.91

5) the gain is now split into unrecaptured depreciation and capital gains

uncaptured depreciation $29,090.91

cap gain $45,000.00

6) And the tax is computed on each

recapture rate 25%

cap gains rate 15%

recap tax $7,272.73

capital gains tax $6,750.00

7) add them up to get the total tax bill

total tax $14,022.73

Do notice that each year you had a deduction of just under $3000.  This is often touted as a "tax benefit" and naive buyers are told you can deduct this against ordinary income.  That may or may not be true, depending on several factors.  If its not, and it's not for a lot of rental investors, then this deductions you cannot take as you hold the property become "carry forward passive losses".  Then when you sell a property, you can use those carry forward passive losses to offset the gains on the sale.  If you have a portfolio of properties, you can use the carry forward losses from all of them to offset the gains on a sale of just one.

nice work, Jon and Wayne. 

Also, thank you, I did not realize the recapture rate was 25% vs being taxed as ordinary income. 

@Kenneth LaVoie the tax rate on unrecaptured depreciation actually is your ordinary income rate.   However, it's currently capped at 25%.  So, if you're in the 28% or higher tax bracket, you don't have to pay back all of the depreciation.

@Linda Weygant  thankfully I have a CPA.   I gave up doing my own taxes long ago.

Amusing how promoters tout depreciation as one of the big attractions to buy and hold, when in fact you have to recapture in sale year.  Just think, if in recapture year your ordinary income put you in a higher tax bracket than previous deduction years you would actually be paying more tax than if you never depreciated at all, since recapture is taxed at your then ordinary income tax rate.

Thank you all for a great discussion.  I've been investing for a while and have really never been concerned with the implications of taxes due on sale.  This has been a great learning point for me.

Special thanks to @Jon Holdman for really laying out the numbers for us in an easy to consume fashion.

Jon,

A couple up question: 

1.)  Can you point us to a reference or help further explain what you mean when you mentioned "carry forward passive losses"?

2.)  How does it affect the net outcome?

Thank you for your time.

Cheers,

-Sam

The IRS has pretty good reference material on their web site.  I don't have the publication number, but there is one dealing with rental properties.

Taxable rental income is the amount of income (rent, laundry, etc.) you collect less all expenses.  Many expenses are straightforward - maintenance, taxes, insurance, legal & accounting charges, interest (though, not the principal part of your payment), etc.  This is money you spend in one year and you can deduct in the same year.  Other expenditures have to be capitalized and depreciated.  Those are improvements (e.g., an addition), or major items like roofs, appliance, flooring, or furnaces.  Capitalized means you spend the money in one year but have to deduct it over several years.  How many depends on the specific item.  When you first spend the money the basis of the property (i.e., its value) increases by the amount you spend.  So, if you spend $2500 on new flooring, that increases the value of the property by $2500 at the moment you put the flooring in.  Then, over the next five years, the basis is reduced by $500 each year for the depreciation on that flooring.  After five years, the IRS assumes its now worthless.

The single biggest item in that category are the "improvements" on the property when you buy it. That is, the house itself, if you buy an SFR. Not the land, that doesn't depreciate. But when you buy a SFR, the value of the house itself is depreciated. You spend the money all at once - up front. Then each year you can take 1/27.5 of the value of the house (not land) as a deduction.

The implication with depreciation is the item being depreciated "wears out" over that period.  So, its losing its value as you hold it.  The depreciation deduction and the corresponding reduction in basis reflects that degradation.  And, indeed, if you had a house that had nothing done to it for 27.5 years you would use words like "dated" or "deferred maintenance" to describe that property.  And it would be worth significantly less than the same house than had been maintained and updated over the last 27.5 years.

After you subtract all your deductions, you're left with your net taxable income.  Now, for a good (profitable) rental, that's a positive number and you have to pay tax on that.  That's a good thing.  It means you're making money.  But crummy rentals often end up with a negative number for the net taxable income.  That is, a "loss".  Its a "passive loss" because rentals are considered passive investments.  That's as compared to an active business like a shoe store.  Or fix and flipping, wholesaling, property management, developing, etc.

Sellers of crummy rentals like to point out you can deduct that passive loss against other income.  They will say that if your passive loss on a rental is $1000 a year, you can then deduct that $1000 from your other income, saving yourself $280 in taxes assuming you're in the 28% tax bracket.  

They often neglect to point out the limits on the ability to offset ordinary income with passive losses and the tax on unrecaptured depreciation.  

Strictly speaking, you cannot offset ordinary income with passive losses.  Once this was a source of very lucrative "tax shelters".  That is, investments that generated large passive losses that a taxpayer used to offset a significant portion of their income.  Those have largely been killed.  However, there is a "special allowance" that may apply in some circumstances.  If your AGI (individual or joint) is under $100K, you can use up to $25K in passive losses to offset other income.  If your AGI is over $100K, the $25K special allowance is reduced by $1 for each $2 of AGI over $100K.  So, at $150K AGI you cannot use passive losses at all to offset other income.  And, because many folks who invest in rentals have fairly good income (which is what produces the money they're investing) many rental investors get caught by this limitation.  

There is an extra twist on this.   If you are a "real estate professional", you can use these passive losses without limit.  A real estate professional must spend at least 750 hours doing real estate related work and (and this is the kicker) must spend more hours on real estate than anything else.  So, if you have a full time job, you need to spend 2081 hours a year on real estate.  Even 750 hours amounts to 15 hours each and every week.  That's tough to do with rentals.  I estimate it would take 30-40 rental units to need to spend 750 hours a year managing them.  The IRS generally agrees, and their audit guidelines specifically address a situation where someone own only a few rentals and tries to claim this status.

And, as discussed above, that depreciation deduction is reducing your basis, which has the effect of increasing your gain when you sell.  And causes you to have to pay the tax on unrecaptured depreciation.  But remember than those big improvements you're depreciating do increase your basis.  And, even all that routine maintenance increases the value of the property.

Not all is lost, though.  If you do have passive losses you cannot use to offset other income, you accumulate those from year to year.  Those are your "carryforward passive losses."  You, and not the property, are accumulating those losses.  When you sell a rental property, you can now apply your accumulated losses to that sale.  That will reduce your gain.

Another factor to consider is that tax law can and does change over time.  About the best you can do is to make purchase decisions based on current law.  But, changes are possible and may dramatically affect your investment.  A big fund with lots of money at risk would do scenario planning.  That is, they would define different possible scenarios of what might happen.  Not just with taxes, though that would be a factor.  And then they would evaluate the outcome under these different scenarios.  An investment that makes money only in specific scenarios is less attractive than one that makes money in a broad set of scenarios.  

@Jon Holdman you know this business well What a great thread to encounter. I myself am looking at getting my equity out of the SFR I own and into units. I want to minimize expenses as well as taxes. Hopefully the multifamily market doesn't get hot right when I 1031 the equity into the multi. Great thread!