The tax rules on selling real estate whether it is residential real estate or commercial real estate can be very complicated and you should know the basic rules before you decide to sell and set a selling price. Below is a summary of some of the rules when selling a real estate. Whenever selling real estate a comprehensive review of legal and tax implications should occur.
Sale of Personal Residence Property
Congress has provided certain tax incentives for home ownership and one of these incentives is the exclusion of gain in certain circumstances when selling a personal residence. These rules have changed several times over recent years but currently up to $500,000 of gain on the sale of personal residence property can be excluded by a married couple ($250,000 for a single person) if the residence has been used by the couple as their primary residence in 2 of the last 5 years. This exclusion cannot be used more than once in the last 2 years or if the property was acquired in a like kind exchange. You can still exclude some gain on the sale of a primary residence if you: (i) changed your place of employment; (ii) had a sudden health issue or (iii) underwent some other unforeseen circumstance or hardship. (See IRS publication 523 for further details.)
If the capital gain (difference between net selling price and original cost of the residence plus improvements) exceeds the exclusion amount, then the gain is taxed at the long term capital gain rate if held more than 12 months. These rates vary from 0%, 15% to 20% depending on your tax bracket.
Sale of Commercial or Rental Property
The tax implications on selling commercial or rental property are totally different than selling personal residence property. First, you need to determine the tax basis of the real estate which is computed by taking the cost of the property plus improvements and then subtracting depreciation on the property over the years. The difference between this basis and the net selling price then gives you the gain on the sale of the property. There are several planning options you have to use to either defer the gain or eliminate it entirely discussed below. You should also be aware that you first need to determine if the gain is taxed at normal long term capital gain rates if the property has been held for at least 12 months (0%, 15% or 20%). The net investment tax may also apply to add another tax at 3.8% depending on adjusted gross income.
Any depreciation that the seller has taken on the property over the years must first be recaptured on a sale if the selling price exceeds the tax basis of the property. So, first the gain on recapture is taxed at the seller’s top marginal rate up to 25% and then once all the depreciation is recaptured the remaining gain gets taxed at the lower capital gains rate.
A seller usually has the option to spread the gain over several years if the sale is on an installment basis. However, be careful, as normally the tax on recapture income cannot be deferred and is due for the year of sale.
I have many clients who come to me for estate planning, and they want to sell business property to their children or gift it to them to reduce their estate for Medicaid planning purposes. While there have been recent proposals to eliminate the step up in tax basis on death, under current law property owned by a decedent at death is stepped up to its fair market value and all the gain that would have been due on a sale is eliminated. The new owner can sell the property at the new stepped-up basis with no capital gain being triggered. Note that on a gift of property the tax basis of the party giving the property carries over to the party receiving the gift so on a later sale this built in gain gets taxed. Many elderly clients choose to retain their property so their heirs receive the free step up in basis at death by inheritance rather than making a gift to a child where the basis carries over.
One last option to consider when disposing of commercial or rental property to defer capital gains is to consider doing a like kind exchange under section 1031 of the internal revenue code.
Trade or business property can be exchanged for trade or business property and if the new property has a fair market value exceeding the fair market value of the property disposed of the gain on the exchange can be deferred or entirely eliminated at death. These rules are very complex and beyond the scope of this article but sometimes can be used to defer capital gains. The party exchanging the property should be aware that any gain that is deferred in the exchange reduces the tax basis of the property received in the exchange which in turn reduces potential depreciation deductions and also increases the later gain on the sale of the property received. There are also significant costs in structuring the exchange so that it will qualify for section 1031 and sometimes the cost of doing the exchange plus the reduced depreciation deductions and later increased gain cause taxpayers to forego a like kind exchange.
In summary extensive planning should take place when disposing of real estate to maximize the net after-tax proceeds from the sale.
Hurtado Zimmerman SC