Rental Property Sales – A Simplified Look

When one has rental real estate, the sale of that property can have significant tax ramifications. Some of these are good, while others can create significant tax liabilities.

First, the good news. If there were losses that could not be deducted due to the passive activity rules, these losses may be deducted on Schedule E in the year of sale, assuming the property is sold in a taxable transaction.

Determining gain or loss on the sale can be a daunting task. Due to depreciation recapture, the gain and tax can be much larger than anticipated.

As far as the sale itself is concerned, first determine the adjusted basis. This starts with is the original cost plus any capital improvements. These are improvements to the house that were not expensed when incurred, but depreciated over time.

Then subtract any depreciation that was allowed or allowable. Allowed or allowable means that the IRS reduces the basis in the house for depreciation whether it was deducted or not. If depreciation was not taken, Form 3115 can be filed to claim any depreciation not taken. This is a very complex form and should usually be prepared by a professional.

Next, subtract any costs of sale. This includes any broker’s commissions, seller-paid closing costs, and the like. Costs incurred in getting the house ready to sell, fixing up, staging, etc. may also be deducted.

This gives the adjusted basis. Subtract the adjusted basis from the sale price and that is the taxable gain. But there is more.

Any gain represented by depreciation is subject to depreciation recapture at a maximum rate of 25%. The actual rate is determined by your marginal rate for ordinary income. For example, the house sold for $250,000. Adjusted basis was $100,000 for a gain of $150,000. However, $50,000 of that gain was due to that amount of depreciation, so that’s subject to the maximum 25% rate with the remaining $100,000 taxed as capital gains.

The rate on the capital gain portion depends on the marginal tax bracket. If taxable income is in the 10-15% bracket there is a zero rate that applies. For married filing jointly, that would be for taxable income up to $75,300. If taxable income is in the 25 – 35% brackets, the rate is 15%. This would be for taxable incomes of $75,301 – 466,950. Above that, the gain would be subject to a 20% rate. If the gain from the sale of the house takes overlaps brackets, the gain would be subject partially at zero and partially at 15%

There is another fly in the ointment, thanks to The Affordable Care Act. If modified adjusted gross income is in excess of $250,000 a 3.8% Net Investment Income Tax applies. This is levied on net investment income. Investment income for this purpose includes: interest; dividends; capital gains from sale of stock, bonds, mutual funds, investment real estate; capital gain distributions from mutual funds; rental and royalty income; nonqualified annuities; and business income from passive activities. The net investment income tax applies to the lesser of net investment income or the excess of modified AGI over the threshold amount.

The sale is reported on Form 4797 and Schedule D. Your local CPA or Enrolled Agent can help you navigate these treacherous waters, especially if a Form 3115 is involved.

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