How would this be taxed?

Question

Hello BP folks.

My wife and I bought our first home in 2005 for 131k. In 2014 we moved out of it and it’s been a rental since. If we sell it today for 275k, would we be hit for capital gains and income tax for the difference in purchase price and sale price?

Will Dixon · Answer

Unfortunately you are out of the window to take advantage of the IRC Sec 121 Primary Home Sale Gain Exclusion. This would have allowed you to pay no tax on the gains had you lived in the home for any 2 of the last 5 years. Unless you want to move back in for the next 2 years to take advantage of that rule, you have two other options.

1. Sell the home and pay capital gains on 275k-131k. If you have made any capital improvements on the property that will reduce this number. In addition, since you have been using the property as a rental, you have likely been depreciation the property. You will need to pay taxes on the depreciation recapture amount.

2. Sell the home and 1031 exchange the proceeds into another investment property. This allows you to defer taxation until whenever you sell the next property, which could be 1031 exchanged again. Typically you do not pull any money out, or else it will be taxed.

Option 1 leads to paying taxes and walking away with cash in hand while option 2 allows you to avoid taxes but your funds remain tied up in the property.

Dave Foster · Answer

@Jason Krawitz, yes that's correct.  There are some regulatory things you have to follow.  From the date of your sale you have 45 days to continue shopping around to identify your potential replacements.  And 180 days from the date of your close to complete the purchases.  There are a few others but it's not an incredibly onerous process.

Most national QIs will charge you $750 - $1000 for an exchange.  An internet only firm with limited personal exposure and consulting will be cheaper.  An attorney doing a few a year will be more expensive due to scale.  And things tend to be higher on each coast (the cost of palm trees and sky scrapers I guess).

You've got a present from me in your BP inbox.

Dave Foster · Answer

@Jason Krawitz, Yep that's pretty much it.  The way your accountant looks at it is that they figure an adjusted cost basis.  This is your acquisition price +plus capital improvements - depreciation.  So in your case it would be 131+31-$17K ish (depreciation = $145K.

This adjusted cost basis is subtracted from your net sale ($275K minus closing costs so maybe $260K ish) = a gain of $115K which consists of a capital gain of $98K (taxed at 15% federal probably) and $17K of depreciation recap at 25%.

Total tax - roughly $20K ish.  If you do the 1031 you defer all of that both capital gain and depreciation recap.

Dave Foster · Answer

@Jason Krawitz, If you sell then those improvements would factor into your adjusted cost basis that would determine your actual gain and tax.  However, there's one more little potential gotcha in looking at the dates of . your purchase and conversion into rental.  Your basis will be determined by the lower amount of your purchase price or the FMV when you put it into service.  Unfortunately it looks like you may have bought it at the top and turned it into a rental shortly after the market had  bottomed out.  That would make your basis potentially lower which = more profit and tax.  Something to watch out for.

The 1031 option listed by @Will Dixon is the most common decision made by real estate investors because it allows you to use the deferred tax to leverage into more and larger properties.  In your case this could be a real kick start for you.  If I read your profile right you paid this house off and have been using it for a rental.  That implies a couple of things - First that you've got a substantial amount of equity to be used in your next purchases.  And secondly that "trapped equity" is not giving you as superior a return as it could.

the 1031 would allow you to sell that and actually purchase more than one replacement property using the proceeds including profit and tax as down payments.  This could get you into different classes of properties and in numbers that would significantly boot your NOI and ROI.

Steven Hamilton II · Answer

You would have to recapture the depreciation taxed on the part below 131k. You must do this EVEN IF YOU DID NOT take depreciation. There are procedures for correcting it to get the missed depreciation in that year.

You would have capital gains on the amount over 131k.

So yes, you'd have a tax bill unless you have a ton of capital losses hanging around that may offset it.

Basit Siddiqi · Answer

@Jason Krawitzit looks like you will be required to pay capital gains tax on $275,000 less selling expenses less capital improvements($30,000) and Original basis($131,000).You will have to pay tax on depreciation recapture on the amount of depreciation taken during the years it was a rental.

Michael Plaks · Answer

Beware Trojans bearing gifts  :)

Michael Plaks · Answer

No, it was not reduced

How would this be taxed?

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