To estimate the federal income tax you will have to pay if you sell the property and do not do an exchange, let’s use the following example to determine the tax you will have to pay.
You sell a property for $180,000 and have $15,000 of selling expenses. Your starting cost basis was $120,000, and you made improvements worth $10,000. You took depreciation of $60,000.
| Taxable Gain if property is sold | ||
| Taxable Gain if property is sold | ||
| Selling Price | $180,000 | |
| Less: Selling Expenses | -$15,000 | |
| Equals: Adjusted Selling Price | $165,000 | |
| Starting Cost Basis | $120,000 | |
| Plus: Improvements | +$10,000 | |
| Equals: Adjusted Cost Basis | $130,000 | |
| Less: All Depreciation Taken | -$60,000 | |
| Equals: Adjusted Tax Basis | -$70,000 | |
| Total: Taxable Capital Gain | $95,000 | |
Starting Cost Basis: If you obtain a property in a straight purchase, then the owner’s starting Cost Basis is basically the purchase price with some additional acquisition costs. If the property was received in some other way, such as part of an exchange, an inheritance, on death of a spouse, or in a partnership distribution, you need to know what basis was assigned to the property when received. Any improvements to the property are added to the starting cost basis.
Adjusted Tax Basis: After adding any improvements to the starting cost basis all of the depreciation taken or allowed is subtracted to obtain the Adjusted Tax Basis.
Total Taxable Gain: The potential Taxable Gain is the Adjusted Tax Basis subtracted from the Adjusted Selling Price.
| Adjusted Selling Price | $165,000 |
| Adjusted tax Basis | -$70,000 |
| Taxable Capital Gain | $95,000 |
If the property is sold this is the amount that will be added to your Taxable Income. The amount of Capital Gain !!!
Remember: When selling real estate Capital Gain is: PROFIT + Recaptured Section 1250 DEPRECIATION.
NOTE: The debt on the property is not considered when figuring the capital gain.
Federal Tax Due: While the long term capital gains rate is 15% (effective for property transferred on or after May 6th, 2003) on the profit from the sale of real estate, the computation of the total federal tax due is complicated by the separate 25% tax rate for recapture of depreciation.
| Federal Tax Due on Gain of Property Sold | ||
| Recapture of Section 1250 Depreciation | $60,000 x 25% | $15,000 |
| Capital Gain on Profit | $35,000 x 15% | $5,250.00 |
| Total: Federal Tax Owed | $20,250 | |
In the above example, if you were to do a totally tax-deferred exchange, you will defer $95,000 of taxable gain and have $20,250 more to reinvest in real estate.
Reinvestment: See the Reinvestment Rules page for dollar requirements when purchasing the replacement property.
Additional Tax Impact: Starting in 2013 when a property is sold, in addition to the Capital Gains tax and recapture of depreciation a tax payer must give consideration to at least two other new tax provisions that can impact the final income tax bill. These are:
- The 3.8% Medicare Tax Rules and Thresholds.
- Personal Exemption and Itemized Decuction Limits.
3.8% Medicare Tax Rules & Thresholds. If your income is over the threshold amounts, the amount you will owe is based on the lesser tax on your total net investment income or the amount of your MAGI that exceeds $200,000 for individuals, $250,000 for couples filing jointly, or $125,000 for spouses filing separately. By definition, MAGI includes your adjusted gross income (AGI), wages from work, net investment income (NII), qualified distributions from a retirement plan such as a traditional IRA, 401(k), or 403(b), and any foreign earned income exclusion you may have had.
In other words, you’ll owe the 3.8% tax on all your investment income, OR, if your wages alone already are higher than the income thresholds, you’ll owe tax on the lesser of net investment income OR tax on portion of MAGI that exceeds the thresholds.
- First, you must have MAGI over the threshold amount, or you do not have to pay any 3.8% Medicare Tax.
- Second, if you have a high MAGI amount above the thresholds suggest you compute both taxes and select the one that is lesser.
- Total net investment income, including capital gains, times 3.8% to get the first possible tax; then multiply MAGI amount over thresholds by 3.8% to get second possible tax, then select the lesser as the additional tax you will have to pay.
If a taxpayer has a question, IRS has added to IRC Section 1411 recently to list/explain everything that is net investment income(NII). For example, if the investor is not an active participant in a business the income will be shown in NII. Any rental property sold by those who qualify in accordance with IRS rules as “real estate professionals” is not considered passive and thus will not be counted as net investment income.
The gain deferred in a 1031 exchange is not included in your Adjusted Gross income (AGI) or Net Investment Income (NII). If you sell an investment property with a lot of gain, after January 1, 2013, there is a good chance the taxable gain will put your Adjusted Gross Income (AGI), the last line on page 1 of IRS Form 1040, above the Modified Adjusted Income (MAGI) thresholds, causing you to have to pay an additional 3.8% Medicare tax. The law also provides different rules for a 3.8% tax on estates and trusts.
| Example: Mr. & Mrs. Smith file a joint return with: | |
| Joint investment income of | $150,000 |
| Plus: Salaries of | +$200,000 |
| MAGI (AGI) | $350,000 |
| The 3.8% surtax would apply to $100,000 of income (MAGI of $350,000 minus $250,000 threshold vs. $150,000 of net investment income). Tax would thus be $3,800 (3.8% x $100,000). | |
Also if a 1031 exchange is done the capital gain deferred is not included in your AMT
computation.
Personal Exemption and Itemized Deduction Limits. The threshold for both of these restrictions is AGI of $250,000(single) or $300,000 (joint return). The personal exemption (est. $3,900 per person) phase out (PEP) is for each $2,500 of AGI over the threshold the personal exemption is reduced by 2%. Itemized deductions are basically reduced by 3% of the amount which AGI exceeds the threshold. Thus the overall impact of a sale may be to lower the reductions a taxpayer can take.
Note: Additional State tax may also be due if the property is sold.
Those principal residence homeowners who have more gain than the IRC Section 121 exclusion
provides and who also qualify for a 1031 exchange can, in accordance with Revenue Procedure 2005-14, combine the two tax savings and potentially totally avoid the 3.8% tax, exclude or defer all capital gain and depreciation recapture.
While the above gives good overall coverage of the impact of what taxes you may have to
pay, it is recommended you consult with a CPA or other tax professional before taking non-
reversible action.