And the rental property saga continues! Last week, we did a rather #edgy take on allowable business deductions for rental properties and the implications of depreciation. It was so #edgy that 3 people packed up and unsubscribed from this newsletter. And honestly, I’m glad they’re gone. They were only holding me back. Now that it’s just us gals, we can talk about the tax implications of selling a rental property.
If you remember from last week (you don’t), we talked about a really important concept called depreciation. Depreciation is when you expense the cost of a property over time. For residential properties, that time frame is 27.5 years, and for commercial it’s 39 years. You can also take depreciation on many improvements or equipment you purchase for your property. An example would be an A/C unit, windows, or a lawnmower for the yard. These all have different useful lives, and some can be expensed entirely in the year of purchase by using bonus depreciation or section 179 depreciation. The most important concept to understand about depreciation is that it a tax deferral – not a tax write-off. We are taking a deduction for something now, but that may come back to bite us when we sell it. Let me explain.
I purchase a property for $100,000. I make improvements totaling $20,000, all of which I’m able to take bonus depreciation on and write off in the year I purchase them. By the time I’m ready to sell my property, I’ve also taken $20,000 in depreciation on the building itself. I list and sell the property for $150,000. If I’m the owner of the property, I’m thinking I need to prepare myself for a $30,000 gain on my taxes ($150,000 sale – $100,000 original cost – $20,000 in improvements made = $30,000 gain). Unfortunately, I’m very wrong. I wish I had found an #edgy newsletter that would explain these things to me.
The reason I’m wrong is because depreciation is tax deferral. That means that at some point, it comes back to bite me because I’ve benefited from the deductions in the past. Although my original cost basis in the property is $120,000 ($100,000 purchase price + $20,000 improvements), I’ve taken $40,000 in tax deductions already from depreciation. When calculating my cost basis in the property, I have to subtract any depreciation deductions I’ve taken for purposes of calculating my tax gain. In other words, my tax basis in the property is $80,000 ($100,000 purchase price + $20,000 improvements – $40,000 depreciation). So when I sell it for $150,000, I technically have a tax gain of $70,000. This can be extremely painful if you’re not expecting it.
As far as the actual tax calculation goes, you have to break your gain into 3 parts in this specific scenario. The first is that $30,000 gain that was calculated prior to messing with any of the depreciation. This is taxed as a capital gain, which is generally a favorable outcome for tax purposes. If you’ve held the property for longer than 1 year, you’ll pay long-term capital gains rates. This means you’ll be taxed at either 0, 15, or 20% (excluding net investment income tax and state taxes) depending on your income. That takes care of $30,000 of our gain, so we’re left with $40,000. Of this, $20,000 was depreciation on real property, meaning the depreciation we took on the building (not the improvements). Depreciation add-back from real property is taxed as ordinary income, but only up to a maximum rate of 25% (excluding state taxes and net investment income tax). This is called section 1250 property, and generally includes anything that’s depreciated over 27.5 or 39 years. It’s taxed at your ordinary marginal rates until that marginal rate exceeds 25%. The remaining $20,000 was from the depreciation we took on our improvements, and that just gets taxed as ordinary income, meaning a current max rate of 37% federally. However, your marginal tax rate will be based on the other income on your tax return. For most people, this is somewhere between 22%-32%.
See what a nightmare this can be? I’ve seen scenarios where people have a tax bill that is as much or more than they walked away from the sale of the property with. However, what’s more common is that there are suspended losses (another concept from last week) that the person is able to take in the year of sale. This can help offset some of the pain. Join us next week when where we’ll talk about how a 1031 exchange can help with some of this burden.