CAPITAL GAINS, SECTION 125O PROPERTY, AND DEPRECIATION RECAPTURE
Capital gains tax on the sale of your Section 1250 Property, your investment property, along with the Depreciation Recapture, are your primary concerns when you sell your investment real estate.
You can avoid both by doing a Section 1031 Like Kind Exchange.
Section 1250 Capital Gains, and Depreciation Recapture Tax, caused by taking accelerated depreciation and bonus depreciation, can eat up a large part of your profits.
And those profits represents money that you could be investing in more real estate.
Look at Free Money to see how this works.
In this article I will explain everything you need to know about:
* section 1250 property,
* straight-line depreciation,
* accelerated depreciation,
* bonus depreciation,
* depreciation recapture, and
* how to use Section 1031 to keep all of your profit, tax-deferred, and reinvest it.
If you are not familiar with any of the terms, check out our Dictionary.
You should also review the 1031 Exchange Rules.
And take a look at About to see my qualifications for making this presentation.
It's Like A Seminar In A Book
CAPITAL GAINS TAX SCENARIO
The easiest, best, and quickest way to explain a concept is to use real numbers and real people.
So this is our scenario, and don’t be overwhelmed, because we’ll go through these one-by-one so you will understand (you are about to become one of the smartest people in the room):
:: Alan Adams bought a Duplex ten years ago for $200,000 cash.
:: He assigned $20,000 to the land, $180,000 to the building.
:: He began claiming depreciation on the $180,000 building.
:: He spent $30,000 for two garages, began depreciating.
:: He spent $20,000 for furniture, began depreciating.
:: He has claimed $65,400 in straight-line depreciation on the Duplex.
:: He has claimed $7,644 in straight-line depreciation on the garages.
:: His total straight-line depreciation claimed is $73,044.
:: He has claimed $15,200 in accelerated depreciation on the furniture.
:: His total overall depreciation claimed is $88,244.
:: His Basis in the property is $161,756 (200,000 plus 30,000 plus 20,000 minus 88244).
:: Bob Baker has offered him $400,000 cash for the Duplex.
:: If he accepts, his Capital Gains will be $238,244 (400,000 Sales Price minus 161,756 Depreciated Basis).
:: $15,200 of the $238,244 will be Accelerated Depreciation Recapture, taxed at 39.6%, resulting in $6,019 tax.
:: $73,044 of the $238,244 will be Straight-line Depreciation Recapture, taxed at 25%, resulting in $18,261 tax.
:: $150,000 of the $238,244 will be regular Capital Gains (400,000 minus 200,000 minus 30,000 minus 20,000) and will be taxed at 20%, resulting in $30,000 tax.
:: The total tax liability of Alan Adams on his $238,244 of Capital Gains will be $54,280 (6,019 plus 18,261 plus 30,000).
READING TIME: 13 minutes; or just click on what you want in the Table of Contents.
CAPITAL GAINS TAX
Your rental property is classified as Section 1250 Property, and any capital gains that you make on the sale of your 1250 Property is called Section 1250 Gain, and that profit is subject to capital gains tax.
In our scenario, if Alan Adams sells his property, he will have the following questions:
1. Is this a taxable transaction?
2. If so, what type of tax are we talking about?
3. How much is the tax?
4. What other factors besides the tax must be considered?
5. What are the bottom line numbers for this transaction?
SECTION 1250 GAIN
The IRS considers everything that you own to be a capital asset, and if you sell a capital asset, especially Section 1250 Property, for a profit, you have a capital gain.
A capital gain in a type of income, and is taxed at a rate called a capital gains tax rate. The capital gain tax rate is different for each taxpayer, but varies from 0% to 20%, depending on your income bracket.
Adams bought his Duplex for $200,000 and he is selling it for $400,000 so this is a taxable transaction.
And the tax we are talking about is Capital Gains Tax.
There are two types of capital gains tax, short term capital gains and long term capital gains.
Short term capital gains occurs when the taxpayer has held the capital asset for one year or less.
Long term capital gains occurs when the taxpayer has held the capital asset for at least a year and a day.
Adams has held his capital asset, the Duplex, for ten years so we are talking about long term capital gains.
A Section 1031 Exchange cannot be used to defer taxes on ordinary income, which is the tax rate for short term capital gains.
So you can only do a Section 1031 Exchange on long term capital gains, which means that you must have owned the property for at least a year and a day.
So, there is a minimum holding period, even though you will read a lot of other content on real estate investing saying that there is no minimum holding period. This is just another example of misinformation on the web.
To explain what I mean, go to the Form 8824 and look at the form on which you will report you Section 1031 Exchange, and you will see the rules.
The tax liability of Adams will depend on his tax bracket. He happens to be a highly-compensated individual in the highest marginal tax bracket of 39.6%, so he will pay 20% tax on his capital gains.
Remember, we are only dealing with Federal taxation here because all states with state income tax have their own tax code.
Some municipalities also have income taxing power, so there will probably also be state taxes, and possibly municipal taxes, due where the taxpayer lives.
Combined, these other taxes could total as much as 10%.
We are also not dealing with the additional 3.8% Medicare Tax that is being called an Investment Tax.
The total could be another 10-15% in addition to the federal tax, which is even more reason for you to do a Section 1031 Exchange.
For Adams, his pure capital gains that will be taxed at 20% will be computed as the difference between what he invested in the property and what he sells it for.
He bought the property for $200,000 and if he sells it for $400,000 he will have $200,000 of pure capital gains. We will ignore for the moment the $30,000 that he spent building two garages and the $20,000 that he spent on new furniture. We will add those later to illustrate a point.
So, if he sells for $400,000 he will have $200,000 of pure capital gains.
But he has also claimed depreciation. We will cover depreciation below.
When a taxpayer buys an investment property such as a Duplex, the money he pays is not an expense that can be deducted from the income that the property produces before the taxable income amount is determined.
Even if the taxpayer borrowed all of the money to buy the Duplex, the monthly principal payments on the note cannot be deducted.
Only the interest paid on the loan, because interest is a deductible business expense, can be deducted from the property’s gross income.
It seems unfair, and maybe is, but the way the IRS makes this unfair situation into a fair situation, and encourages investors to put their money into such projects, is through what is called “Depreciation Allowance”.
Depreciation Allowance is not an actual “out-of-pocket” expense, but the taxpayer can deduct it like any other business expense as though it were actually paid, because it is an “expense allocation.”
Adams paid $200,000 for the Duplex, but part of that price was for the land, and land cannot be depreciated, only the building, the Section 1250 property, that is on the land.
The theory behind this is that land is not “used up” in the process of producing income, like the building is being “used up.”
So Adams allocated $20,000 value to the land, and $180,000 value to the building.
This means that the $180,000 that Adams allocated to the Duplex can be deducted in equal amounts each month until he deducts the entire amount paid, plus improvements. The period of time over which the property is depreciated is 27.5 years because it is Residential Rental Income Property.
This results in a yearly Depreciation Allowance of $6,540 and Adams has owned the property for ten years, so the total amount of Depreciation he has claimed is $65,400.
But this amount will be subject to Depreciation Recapture.
Now we are ready to run the numbers.
Computing Tax Liability
So, in our first Example, Alan Adams bought a Duplex ten years ago for $200,000 cash and he has made no capital improvement.
He has claimed $65,400 in Depreciation.
He sells the Duplex to Bob Baker for $400,000 cash.
What are the steps for computing his tax liability?
Determine His Basis in the Property
“Basis” is the amount that Adams paid for the property, plus any capital improvements, and minus any allowable depreciation.
Be warned: you are charged with having taken the depreciation that you were entitled to whether you actually put it on your tax return or not.
Now, remember this general rule for determining Basis, you will use it every time you sell. Basis is Purchase Price plus Improvements minus Depreciation.
Adams paid $200,000 for the property, and made no capital improvements, and deducted $65,400 depreciation.
Therefore, his depreciated basis in the property now is $134,600.
Determine His Sales Price
Later, after this, for the Sales Price we will use the Sales Price of $400,000 less any expenses of the sale such as closing fees, commission, document preparation, title policy premiums, etc.
But right now, for purposes of this illustration, we will use the round number of $400,000.
Determine His Capital Gains Amount
Capital Gains is defined by the Internal Revenue Service as the difference between his basis in the property and what he sold the property for; in other words, the difference between $134,600 and $400,000.
So, his capital gains amount is $265,400.
Determine His Capital Gains Tax Bracket
We are assuming a rate of 20%.
Determine His Capital Gains Tax Liability
If you thought this was too simple, you were right. So this part is especially for you.
The entire $265,400 is not Capital Gains for tax purposes, even though it is Capital Gains for IRS “definition” purposes. This will make sense in a minute.
The actual capital gains is the difference between what Adams paid for the property and what he sold it for. In other words, $200,000 (400,000 minus 200,000).
But we computed his Capital Gains as $265,400. What is the other $65,400 of his “definition” capital gains?
Is it just coincidental that the number is the same as the amount of depreciation?
You’re right. The other $65,400 represents the depreciation that he took on the Duplex, which lowered his Basis in the property from $200,000 to $134,600 and thereby increased his capital gains by the same amount, $65,400.
So, Adams will be taxed at 20% on the $200,000 of profit, but for the $65,400 he will be required to do what is called “recapture of depreciation” and as long as the depreciation was taken equally over the life of the asset, that is, it is what we call straight-line depreciation, the depreciation recapture amount is taxed at a maximum tax rate of 25%.
If Adams were in the 10% personal income tax bracket, or the 15% personal income tax bracket, the $65,400 would only be taxed at 15% instead of 25%, but he is in the top marginal personal income tax bracket of 39.6% (plus 3.8% ObamaCare tax, but we will be using just the 39.6%), so Adams will pay 25% tax on his “depreciation recapture” of the $65,400.
To sum it up, for his total of $265,400 profit Adams will pay 20% tax on the $200,000 of true capital gains (= $40,000) and 25% tax on the remaining $65,400 of depreciation recapture (= $16,350).
So, the total tax on his capital gains of $265,400 is $56,350.
This was our first Example. In the next Example, we’ll change some of the factors, and see how they change the outcome.
Remember, we are still dealing with a typical real estate sale that does not involve using the provisions of Section 1031 Like Kind Exchange. We are just selling the asset and paying the taxes so that we can understand later what we are saving by doing a Section 1031 Exchange.
Everything is the same as in the previous Example, except that instead of Adams paying $200,000 cash when he bought the Duplex ten years ago, he only used $50,000 from his own money, and got a bank loan for $150,000.
The balance on that loan is now $130,000 and will be paid off from the Sales Proceeds of $400,000.
How does this change his tax liability?
SECTION 1250 PROPERTY
This changes absolutely nothing (except the amount of his “net sales proceeds” which he will be required to reinvest in his Replacement Property, which we discuss elsewhere).
But for purposes of computing his Capital Gains on his Section 1250 property, it does not matter where Adams got the money that he used to purchase his Relinquished Property, whether from his savings account, or borrowed from the bank, or from his mother. He paid $200,000 for the property. Period.
And it does not matter what deductions were made at closing from the money that Adams received from the sale of the property, whether he paid off a bank loan, or went on a cruise. He still received $400,000 for the property.
So his Capital Gains is still $265,400.
CAPITAL IMPROVEMENTS AND CAPITAL GAINS
In this Example, it is the same as above, except that Adams has made capital improvements of $30,000 using his own savings, by adding garages to each unit.
He then put these garages on his Depreciation Schedule, and has taken $7,644 straight-line depreciation on them.
Does this change the amount of his capital gains tax?
DEPRECIATION, BASIS, AND CAPITAL IMPROVEMENTS
Yes. These factors change his tax liability in the following ways.
In previous examples, Adams has taken $65,400 depreciation on the two units, and now he has taken another $7,644 depreciation on the two garages, both straight-line depreciation.
His total depreciation is now $73,044.
Remember, the basis in the property is the purchase price, plus any capital improvements, minus depreciation taken.
The basis is now computed as $200,000 purchase price plus $30,000 improvements minus $73,044 depreciation.
His new basis in the property is $156,956.
Capital Gains is the difference between what the property sold for, and the basis. That computation is now $400,000 minus $156,956.
His new capital gains is $243,044.
Capital Gains Tax And Depreciation Recapture
The portion of the $243,044 capital gains that is subject to depreciation recapture is now $73,044 and is still taxed at 25%, so this number is $18,261.
The remainder of the capital gains, the $243,044 minus the $73,044 depreciation, is $170,000.
You will probably notice that $170,000 is also the true difference between the $400,000 Sales Price and what Adams paid for the property, which was $230,000 (200,000 purchase price plus 30,000 for the two garages).
The total tax liability is now $18,261 plus $34,000, which is $52,261.
Our next wrinkle is to add some Personal Property and see what happens.
This is the same as the previous example, except that Adams decided two years ago to upgrade his units by removing all of the furniture and furnishings, and putting in all new furniture and furnishings, at a cost of $20,000 cash for both units combined.
He had the opportunity to use “accelerated depreciation” to recover his investment quicker, so he chose the Double Declining Balance method and elected to take the Section 179 Bonus Depreciation the year he put the new assets in service, so he has claimed $15,200 depreciation total in the two years.
How does this change his tax liability?
Well, Adams has wandered into the tall weeds.
Let’s follow him and see what happens.
Accelerated Depreciation Versus Straight-Line
Adams has previously taken $65,400 depreciation on the Duplex units, plus $7,644 depreciation on the garages.
Now he has taken $15,200 depreciation on the furniture and furnishings, and this last item of depreciation is the problem.
The $65,400 and $7,644 are both straight-line depreciation, and will be recaptured at the 25% tax rate that Adams must pay because of his marginal tax bracket of 39.6%.
But the $15,200 is not straight-line depreciation.
The $15,200 is accelerated depreciation, a method called Double Declining Balance, plus some Section 179 Bonus Depreciation.
The IRS has a different rule for the recapture of accelerated depreciation. The rule is that the entire amount of such depreciation, up to the total amount of the capital gains created by the transaction, must be recaptured at the ordinary income tax rate of the individual, in this case 39.6% for Adams.
This would result in a tax liability for Adams of $6,019 on the recapture of the $15,200 of accelerated depreciation that he took on the $20,000 of furniture and fixtures.
We’ll add one more wrinkle below and then we’ll close this out with a look at the bottom line on the entire transaction.
SECOND LIEN FINANCING
This is the same as the previous Example, except that Adams got a $30,000 home improvement loan to build the garages instead of using his own money.
Anyway, Adams put a Second Lien on the property, which will be paid off at closing.
Does this change his capital gains tax liability?
SECTION 1250 PROPERTY FINANCING
Since we are assuming a 20% capital gains tax rate, and that number is constant for all of our Examples, the only other factors that affect the tax liability are:
- Purchase Price
- Capital Improvements
- Basis (Purchase Price + Capital Improvements – Depreciation)
- Sales Price
- Capital Gains (Sales Price – Basis).
It does not matter where he got the money to buy the property or where he got the money to make improvements to the property.
It does not matter how much of his proceeds are used to pay off loans.
And it does not matter what he does with the money that he takes away from the closing table.
So: No, financing the capital improvements and paying off the loan at closing does not change his tax liability.
It only chages the amount of his net sales proceeds.
Alan Adams bought a Duplex ten years ago for $200,000.
He spent $30,000 in capital improvements on two garages.
He spent $20,000 on furniture and fixtures.
He has claimed $65,400 in straight-line depreciation on the Duplex.
He has claimed $7,644 in straight-line depreciation on the garages.
He has claimed $15,200 in accelerated depreciation on the furniture.
His total overall depreciation claimed is $88,244.
His Basis in the property is $161,756.
Bob Baker has offered him $400,000 cash for the Duplex.
If he accepts, his Capital Gains will be $238,244.
$15,200 is Accelerated Depreciation Recapture, taxed at 39.6%.
$73,044 is Straight-line Depreciation, taxed at 25%.
$150,000 is regular Depreciation, taxed at 20%.
His total tax liability will be $54,280.
SECTION 1031 DELAYED LIKE KIND EXCHANGE
Now that we have created a Typical Sale to use as an Example, you are ready to dive into the Section 1031 Exchange process.
Go to 1031 Exchange Rules to get started with your Delayed Exchange.