There is a long list of benefits of owning investment real estate. If and when you sell your investment property, you may be unaware of many of the tax implications you may be exposed to as an investor. Once you see the list of potential taxes due on a federal, and a state basis you may be a little confused.
By Al DiNicola, AIF®, CEPA ™
adinicola@namcoa.com
August 10, 2023
DST 1031 Specialist
NAMCOA® – Naples Asset Management Company®, LLC
Securities offered through MSC-BD, LLC
There are a variety of words associated with the potential tax implications such as depreciation, depreciation recapture, capital improvements, capital gains, and others that come into the discussion. For first-time investors it is wise to know these words and be aware of the potential taxes. There may be ways to avoid the immediate payment of these potential taxes.
Does Real Estate Really Depreciate?
This is an interesting discussion based on the theory that real estate appreciates and many look at real estate as building wealth. Investors with rental properties are permitted by the IRS to utilize the IRC Codes to recover certain costs over the life of real estate ownership. The cost must be deducted over the life of owning the property based on a depreciation schedule. Residential schedule is over 27.5 years and all commercial is over 39 years. Many investors simply use a straight-line depreciation schedule. (The 2017 JOBS act did allow for cost segregation with additional accelerated write offs). Raw land does not qualify for depreciation. The value of the land under the real estate is also not able to be depreciation. As a simple example a residential rental property may have an underlying land value of 15% of the acquisition price. That would mean the depreciation would be based on 85% of the acquisition price. Investors look at depreciation as one of the many advantages of owning real estate.
The depreciation is a write-off against the income received from the investment property that will reduce the amount of income from the investment property that is potentially taxed. To illustrate the effect of depreciation let’s assign some numbers to the real estate investment. You acquired a single-family home on June 30th at an acquisition price of $550,000 and you added $50,000 in capital improvements by adding a garage and improving the kitchen which brings your total investment to $600,000.
Know Your Basis
Purchase price and capital improvements are referred to as your cost basis. As noted previously you need to reduce your starting depreciation amount by the value of the land. The land value (for example) is $50,000. This reduced the value of the structure to $550,000. When utilizing the straight-line method, you would divide the $550,000 by the annual residential depreciation of 27.5 years.
Here is an example of the calculation:
- $550,000 divided by 27.5 years would be $20,000 (estimate) per year in depreciation on an annual basis.
- Since the property was acquired June 30 the first-year depreciation would be approximately $10,000.
The acquisition cost (minus the value for the land) and the capital improvements made on the property establish the basis for depreciation. A word of caution regarding depreciation would be that the IRS assumes you are taking depreciation each year regardless if you actually utilize on your tax returns. Most CPAs are aware of this situation.
Depreciation recapture and the potential tax.
IRC § 1250 illustrates the recapture of depreciation once the property has been sold. We have used 27.5 years in our illustration. If the investor owned a warehouse or other commercial building the depreciation would be over 39 years. The IRS considered the depreciation taken over the years of ownership as a GAIN. The depreciation reduced your taxable income you received from the rental property. The depreciation also reduced your cost basis.
Congratulation you sold your property, now what?
When you finally sell the property (after enjoying the depreciation write-offs) a portion of the depreciation taken will need to be paid back to the IRS. After owning the property for over ten (10) years you decide to sell for $800,000. You purchased the property for $600,000 (including $550,000 purchase price and $50,000 in capital improvements). You are closing on December 31.
Depreciation & Capital Gains Calculation.
Here is the total depreciation taken over the 10 plus years. Remember year one was $10,000 and each full year was $20,000. The grand total of depreciation taken was $210,000. This number is important and is used in two calculations.
- Calculation 1 is the depreciation recapture. Fortunately, the IRS recaptures the depreciation at 25% and not at 100%. The depreciation recapture would be $52,500 due to the IRS. Your tax professional will know how to report on IRS Form 4797.
- Calculation 2 establishes the adjusted cost basis. The depreciation of $210,000 is subtracted from the building value of $550,000 to arrive at an adjusted cost basis of $340,000. This adjusted cost basis is used to determine your capital gain on the property. You have accepted an offer to sell the property for $800,000. Your capital gain subtracting the adjusted cost basis is $460,000.
- How your tax responsibility is calculated includes one more calculation. Since depreciation is taxed at the 25% rate the depreciation amount is subtracted from the capital gains to establish the long-term capital gains. As calculated the depreciation taken was $210,000 and when subtracted from the total gain of $460,000 leaves an amount of $250,000. This would be taxes at a capital gains rate of 20% or $50,000. This added to the $52,500 would be a total of $102,500.
There is one more tax for higher income earners. The is a Net Investment Income tax (NIIT) of 3.8% on the entire gain of $460,000. This is $17,480.
Don’t forget your state income tax. If you reside in a state with a state income tax, that tax is also due on the capital gain of $460,000. For this illustration let’s use 5% which may be an addition of $23,000.
The grand tax total may be $142,980.
IRC §1031 permits deferral of capital gains as well as depreciation recapture.
Many real estate investors will utilize the 1031 tax deferred exchange section of the internal Revenue Code. This section has been used by many to accumulate and build generational wealth. If you sell a property outright the IRS requires the reporting and payment of applicable taxes.
There are a number of stipulations and guidelines that need to be adhered to for the 1031 compliance. However, here is a comparison between an outright sale and a 1031 exchange. You may here the terms like kind exchange and utilizing a Delaware Statutory Trust (DST) as an alternative to traditional real estate. We have other articles that focus on the 1031 guidelines as well as replacement strategies utilizing a 1031. Please contact us for more information.
| Taxable Sale | 1031 exchange | |
| Sale Amount | $800,000 | $800,000 |
| Capital Gain Taxes | $50,000 | Deferred |
| Depreciation Recapture Tax | $52,500 | Deferred |
| NIIT | $17,480 | Deferred |
| State Tax | $23,000 | Deferred |
| Reinvestment Proceeds | $657,020 | $800,000 |
| Total Taxes Due | $142,980 | $0 |
The taxes that may be due in the amount of $142,980 could be deferred by utilizing the IRC §1031 Tax Deferred Exchange. You will notice under the Taxable Sale column there would be $657,020 to reinvest. Under the 1031 Exchange you may reinvest the entire amount of $800,000.
DSTs are not for all investors.
The acquisition of a DST is for accredited investors only. Contact your investment adviser for additional details on how a DST may be a solution to your 1031 Exchange and suited for your investment future. For more information on how to properly set up an IRC 1031Tax Deferred Exchange or if you are an accredited investor and would like additional information on a DST contact Al DiNicola at 239-691-8098 or email adinicola@namcoa.com.
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