Tax Planning for Capital Gains on Real Estate Transactions

Depreztaxlaw 24 Jun 2019

When selling real estate, property owners want to know how much tax they need to pay once they sell that piece of real estate.

Not knowing what the true tax effect will be makes it difficult to make a good decision when it comes to selling real estate. This is true whether you are selling a primary residence, a vacation or second home, an investment property, or a business property. That is why it is so important to obtain good professional tax advice to be able to make well-informed and effective real estate decisions. Remember: your real estate agent is a sales professional, not a tax professional, and therefore is not in a position to provide you any tax advice regarding the sale of your property.

What do I need to pay taxes on?

The first thing a real estate owner wonders is – what gets taxed? Is it how much you sell the property for, also known as the gross proceeds of a sale (typically the sales price of the property)? Gross proceeds is the amount reported by the escrow company on Form 1099-S “Proceeds from Real Estate Transactions” to the IRS. Or do you get taxed on the equity in property, which is what you sell it for minus the mortgage payoff?

Actually, neither of the above is correct!

What is actually taxable is the gain on the property. The taxable gain on selling a property is the gross proceeds (selling price) minus the selling expenses and minus the adjusted basis of the property. What is the adjusted basis? The adjusted basis is essentially the purchase price of the property plus buying expenses and capital improvements in the property. There may also be depreciation involved, if the property is an investment property. There are also some other, but less frequent, adjustments.

Remember: You are taxed on the Gain, not the Equity or Net Proceeds. Deprez Tax Law can calculate this for you on your unique situation.

What is the Tax Rate?

While most real estate sellers want to know one tax rate that applies, it is unfortunately more complicated than that. There are several tax rates that apply in different income situations, and therefore it is very important to consult with your tax professional to determine your unique situation.

The federal tax rates for property that has been owned for longer than one year are known as long-term capital gain rates and they can be 0%, 15%, or 20%. The rate or combination of rates applied depend on the income of the owners. This is also true if the property is owned by a Limited Liability Company (LLC) or an “S” Corporation. If the property is held in a “C” Corporation, a different analysis applies. For the part of the gain that is above a combined non-real estate income and capital gain above $250,000, a surcharge of 3.8% tax applies. For investment properties, the part of the gain attributable to previous depreciation taken, or that should have been taken, is taxed at a depreciation recapture rate of 25%.

For Californians and those owning property in California, the California state tax rates that apply to the gain range from 0% to 13.3%. Again, as with the federal tax, the rate or combination of rates that apply depend on the individuals’ other income and the amount of the capital gain.

For a California non-investment property, the highest tax rate scenario is a total tax rate (federal and state) of 37.1% (20% + 3.8% + 13.3%). This means on a million-dollar capital gain, $371,000 would be paid in federal and California income tax combined. The seller would then be netting $629,000 in after-tax gain. For the highest tax rate scenario to exist, a couple filing jointly would have to have taxable income excluding the real estate sale of $1,145,960. A single individual would have to have taxable income excluding the real estate sale of $572,980 (based on 2018 federal and California tax tables). If you have income lower than these figures, you will be paying lower rates of tax on the sale of your property.

As you can see, estimating the potential income taxes associated with a real estate sale can become a little complicated. Expert advice can give you a solid estimate upon which to base your real estate decisions. Deprez Tax Law provides estimates of the tax liability customized to your specific situation and offers you the opportunity to take advantage of a variety of exclusions, credits, deferrals, and planning options that can change your tax outcome. A few are highlighted below.

What is the Main Home Exclusion?

For home sellers, one of the most important real estate benefits is the Main Home Exclusion of Capital Gains Tax of $250,000 for people filing single, or $500,000 for people filing jointly. A variety of conditions need to be met to be eligible for this exclusion. The main requirement is that the owner must have lived in the property and used it as a main residence for at least two years, or at least two out of the last five years, before the close of the sale. Other necessary requirements exist.

For example, if a couple can claim the $500,000 exclusion, on a $1,000,000 gain, only $500,000 would be taxed. This exclusion results in reducing the taxes from the highest tax scenario on the million-dollar gain from $371,000 to $185,500 in federal and California income tax combined, and an after-tax gain from $629,000 to $814,500. So, you can see, this is a significant benefit!

What is a 1031 Exchange?

The second major real estate benefit available to property owners is a Section 1031 Tax Deferred Exchange. Unlike the main home exclusion, this is a benefit available only for investment property, and is not available for a principal residence. Section 1031is not an exclusion, but is instead, a tax deferral. Section 1031 Exchange Deferral is a tax deferral of the capital gains associated with the sale of investment or business real estate by reinvesting all of the proceeds of the sale into “like-kind investment or business property.” If you would like more information on how that would apply to your investment or business property decisions, Deprez Tax Law can provide you a customized analysis of how to use 1031 Exchange for your real estate portfolio.

What are Installment Sales?

In between a standard real estate sale where all the capital gain is taxed in the year of sale and a Section 1031 Tax Deferred Exchange where all the gain is deferred, there exists the concept of an Installment Sale. An installment sale exists when the payments on the sale are received by the seller over more than one year. The taxable gain is spread over the time the installment payments are received. This allows the taxable gain to be realized over a longer period of time, thereby potentially reducing the impact of the taxes and also the tax rates. Whether this is a good strategy for your real estate sale depends on many circumstances that are individual to your situation. Deprez Tax Law can explore those scenarios with you.

What are Main Home Exclusion and Section 1031 Exchange Combinations?

The main home exclusion and Section 1031 exchange deferral are important tax benefits available to real estate owners under the right circumstances. Interestingly, these two major benefits can be combined.

For this to be possible all the separate requirements for each benefit must be met.

A property can qualify as both a main home and an investment property at the time a sale is made. As noted above, a property can qualify for the exclusion if it was the main home for at least two of the five years before the closing of the sale. This means that the property can be rented out for up to the other three years during that five-year period so that the property may also qualify as an investment property.

Other more complicated combination scenarios are possible that need to be analyzed with great care. One such situation is where part of the property is a main home and part of the property qualifies as investment property. An example of that is a fourplex where one unit is the main home of the owner, and the other three units are rented out. These and other scenarios can be discussed with your tax professional at Deprez Tax Law for the best application of the tax law.

Summary

Capital gains tax is a type of income tax that comes about when an asset is sold and there is a capital gain that is subject to taxation. When considering selling real estate assets, it is crucial to understand what the tax cost associated with the sale may be and what tax benefits may be available to reduce or defer the income tax costs. Only by thoroughly understanding these tax elements can a real estate owner make informed decisions.

At Deprez Tax Law, we provide customized estimates of the income tax liability associated with real estate transactions. Based on this information, we then discuss the tax benefits that the real estate owner may be eligible for, and explore the associated business planning, entity organization, and property tax matters.