You're watching episode 20 of the Tax Smart Daily, a daily video series for real estate investors to learn about saving money on taxes and staying out of trouble. I'm Brandon Hall. Before we get started, I invite you to join our Tax Smart Facebook group and our Tax Smart newsletter. Links to both of those are in the description of this video. Additionally, hit that subscribe button. I don't want you to miss any future videos that we drop. We do daily videos, podcasts, live Q&A's, and webinars. Lastly, if anything that I say resonates with you, or if you have any questions, drop a comment in this video. I will engage with you; I'll jump in there and answer. I really appreciate the folks that take 10 to 20 seconds out of their day to drop me a line, so thank you very much for that.

The topic today is: What tax implications do I face when I'm selling rental real estate? Now, I'm going to share my screen because I actually want to walk through an example with you with actual numbers. So, let me do that.

Number two. Alright, so in order to answer what tax consequences do I face when I'm selling my rental, we have to know a few things first. So first, we have to know what did we purchase it for, how much depreciation have we claimed, and what's the sales price net of selling costs. So, let's do this.

So, let's assume that we bought the property for $100,000 way back in the day. Let's actually say it's been five years. Ignore my childish handwriting. So, we bought the property for a hundred thousand dollars five years ago. Uh, let's say that we've claimed—actually, let's not say, let's say that—let me pull this calculator up. So, a hundred thousand dollars, we got to subtract out land, right? So, maybe land is ten thousand, so we got ninety thousand dollars of building.

Now, why do we subtract out land? Well, what I'm trying to do right now is I'm trying to calculate my annual depreciation. So, I can't depreciate land, so I've got to subtract out the value of the land. So, $90,000, even though I've spent $100,000 on a property, $90,000 is my depreciable basis. So, $90,000, I'm going to divide that by 27.5 years. So, every year I'm going to claim $3,272 in depreciation. And just for simplicity's sake, let's just call it $3,200. So, my annual depreciation is $3,200.

Now, over five years, what is that? Three thousand two hundred times five, that's sixteen thousand dollars. So, sixteen thousand dollars. Now, I've got my original purchase price, I've got my annual depreciation, I've got my total depreciation over five years. So, that means that my basis is the net difference, it's the one hundred thousand dollars—my, and we call this adjusted basis, by the way—so it's one hundred thousand dollars minus the sixteen thousand dollars of annual depreciation, or accumulated depreciation that I've claimed annually. Uh, and that gives me a net basis of eighty-four thousand dollars.

Okay, so now I know my basis, eighty-four thousand dollars. Again, one hundred thousand dollar purchase price minus sixteen thousand dollars in accumulated depreciation. So, now if we come over here to the sales side... oops. We come over here to the sales side... am I drawing back up? Let's say that I sell it for a hundred and fifty thousand dollars, $150k.

Now, we got to subtract out selling costs, and for this example, we'll just do five percent. So, I'm actually going to multiply $150,000 times 95% because the selling cost is the additional 5%. So, net of selling costs, my net sales price is $142,500 minus five percent, $142,500. I'm doing this with a mouse, by the way. So yeah, childish handwriting, but with a mouse. And that four right there looks pretty good, I think.

Alright, so my net sales price is $142,500, my adjusted basis is $84,000. So, I'm going to take $142,500 minus $84,000, and that's going to give me my gain. So, this is my taxable gain, $58,500. $58,500.

Okay, now the question though is, I've got my taxable gain of $58,500. What tax do I pay? Well, there's a couple of things going on with this gain. First, this is just my total gain. It doesn't actually tell me what rates that I pay, though, because baked into this gain is $16,000 of depreciation, and I recapture depreciation at a different rate than I pay long-term capital gains. And since we've held it for five years, we're going to pay long-term capital gain tax. So what I want you to walk away from this video understanding is that your $58,000 of gain is not taxed at long-term capital gain rates. Not the entire portion is taxed at long-term capital gain rates. You have to pay depreciation recapture taxes and also long-term capital gain rates on two separate pieces of the gain, which we're going to break out here momentarily.

But the other piece that I want you to really walk away with understanding is that I bought the property for a hundred thousand, I'm selling it for $150,000. Most people, the first time that they do something like this, they go, 'My gain's fifty thousand dollars because I bought it for a hundred, I sold it for 150.' But that's not how it works. Your gain is your net sales price. So net sales price minus your adjusted basis of the property. Adjusted basis takes into account depreciation. So my adjusted basis here is $84,000. Really important to understand that because you may get stuck with tax bills that you didn't expect, especially if you've held the property for a really long time, or if you've been gifted property. When you are gifted property, you inherit the gifter's basis. So, if I gifted you this property, you would inherit my adjusted basis of $84,000, and then if you sold it for $150,000, you would still be faced with this gain. Not true if you inherit the property, not gift but inherit the property. If you inherit the property, then you get a stepped-up basis to the fair market value. So, that's a different kind of can of worms there. But really important to understand that you bought it for 100, you sold it for 150, your gain is not $50,000. You have to take into account depreciation.

So now, of this $58,000 gain that we have, the question is, what amount do I pay on, like what tax rate do I pay on what amount of gain? Well, we have to break this out into two pieces. The first piece that we have, I'm gonna move this down a bit, the first piece that we have is our depreciation. So our depreciation was 16K throughout the hold period, and that means that our capital gain is $58,000 minus $16,000. So our capital gain is $42,500. 42.5K, that was a lot worse of a four that time, huh? Okay, so on my depreciation, there's three types of depreciation recapture. There's Section 1245 recapture, there's Section 1250 recapture, and there's also unrecaptured Section 1250 gain. Now, we covered this in a prior tax-smart video, so I encourage you to go look that up. I can't remember which episode it was, but this is only episode 20. So, it shouldn't be that hard to find.

Uh, in this case though, we're going to say that this is just unrecaptured Section 1250 gain. Unrecaptured Section 1250 gain is the recapture on the building depreciation. So, it's if I depreciated something over 27 and a half years, just straight-line, ordinary, regular old depreciation, then I'm gonna pay recapture tax. But that recapture tax is called unrecaptured 1250 gains. So, the 27 and a half year annual depreciation that I claim will be recaptured, and it's called unrecaptured 1250 gain. That's recaptured at a maximum rate of 25 percent. Let's assume that it's just 25 percent for these purposes. Let's assume it is at the max rate, so 25, so 0.25. And then my forty-two thousand five hundred is going to be taxed at long-term capital gain rates. Today's long-term cap gain rate max is 20, but we also have that 3.8 percent surtax, that net investment income tax, if you're modified adjusted gross income is above $250,000. Let's assume that it is for these purposes. So, we're gonna do a 0.238. That's really your maximum long-term capital gain rate that you can ever claim here.

Alright, so now we got to go back to our calculator. So, $42,000 times 0.238 is $10,115. Ten thousand, one fifteen. And sixteen thousand, let's see, sixteen thousand times 0.25 is four thousand dollars. Four thousand. So, we've got a total here. This is our tax, right? So, our total tax is $14,115. And that is how you calculate the tax burden on selling property.

So, what did we do here? We went, what's our original cost basis? Our original purchase price plus any sort of selling cost, but you know, for this example, we'll just assume that it just equaled $100K even. We held it for five years. Our annual depreciation was $3,200 a year. Um, over five years, that amounts to sixteen thousand dollars. So, one hundred thousand minus sixteen thousand, eighty-four thousand. That's my adjusted basis. Then you take your fair market value, your sales price, $150K, you subtract out your selling cost of five percent, you're left with the net sales price of $142,500. Uh, then you take your $142,500, you subtract out your adjusted basis, and you get your gain, $58,500. But that's not the end of it. We have to figure out what parts of gain do I pay different tax rates on. So, we got to break out this game between our depreciation recapture, unrecaptured Section 1250 gain in this case, and that's taxed at a maximum twenty-five percent rate. It yields a four thousand dollar tax bill, that sixteen thousand dollars. The other piece of this gain is forty-two thousand five hundred dollars. That's my capital gain. It's taxed at a twenty-three point eight percent rate, ten thousand one fifteen. When you combine these, my total tax bill is fourteen thousand one fifteen. And so, my after-tax cash, you know, uh, return is $44,385. So that's what I'm going to have in my pocket, excluding the equity calculation, you know, and that just depends on the loan that I had or lack thereof.

So anyway, that is, uh, that's today's tax-smart video. I hope that you enjoyed it. If you have any questions or comments, jump into the comment section below. I'd love to engage with you. And feel free to follow us online. We've got a lot of different communities and uh different places that you can follow us online to see what we're up to and make sure you're not missing any of these types of videos and other cool content that we're releasing. Thanks so much for watching. Like I said, if you got any comments, leave them below. Hope to see you next time.

https://www.youtube.com/watch?v=VFqIr0GQKSk

1. Determining the Depreciable Basis
   • Purchase Price: $100,000. This is the initial cost of the property.
   • Land Value Deduction: $10,000. You subtract the value of the land because land is not depreciable.
   • Depreciable Basis: $90,000. This is calculated as the purchase price minus the land value. It represents the value of the building and other depreciable components.
2. Calculating Annual Depreciation
   • Depreciation Method: Straight-line over 27.5 years, which is standard for residential rental property.
   • Annual Depreciation: $90,000 (depreciable basis) ÷ 27.5 years = $3,272. Rounded to $3,200 for simplicity. This is the amount of depreciation you can deduct each year from your taxable income.
3. Total Accumulated Depreciation Over Five Years
   • Accumulated Depreciation: $3,200 per year × 5 years = $16,000. This represents the total depreciation claimed over the period the property was rented.
4. Calculating the Adjusted Basis
   • Adjusted Basis Calculation: $100,000 (original purchase price) - $16,000 (accumulated depreciation) = $84,000. The adjusted basis is the original cost minus the total depreciation. It represents the current tax basis of your property.
5. Determining Net Sales Price
   1. Sales Price: $150,000.
   2. Selling Costs: 5%, or $150,000 × 5% = $7,500. These are the costs associated with selling the property, like real estate commissions.
   3. Net Sales Price: $150,000 - $7,500 = $142,500. This is the sales price minus the selling costs.
6. Calculating Taxable Gain
   • Taxable Gain: $142,500 (net sales price) - $84,000 (adjusted basis) = $58,500. The taxable gain is the difference between the net sales price and the adjusted basis.
7. Breaking Down the Gain for Tax Purposes
   • Total Gain: $58,500.
   • Depreciation Recapture: $16,000. This is the part of the gain attributable to depreciation deductions taken in previous years.
   • Capital Gain: $58,500 - $16,000 = $42,500. This is the remaining gain after accounting for depreciation recapture.
8. Tax Calculations
   • Depreciation Recapture Tax: 25% of $16,000 = $4,000. This tax is applied to the recaptured depreciation at a maximum rate of 25%.
   • Capital Gains Tax: 23.8% of $42,500 = $10,115. This rate includes the long-term capital gains tax plus the net investment income tax, applicable if your income is above a certain threshold.
9. Total Tax Liability and After-Tax Return
   • Total Tax: $4,000 (Depreciation Recapture Tax) + $10,115 (Capital Gains Tax) = $14,115.
   • After-Tax Return: $58,500 (Gain) - $14,115 (Total Tax) = $44,385. This is the amount you would have after paying the taxes on your gain.

These calculations show how to determine the taxable gain from selling a rental property and estimate the taxes due, considering both depreciation recapture and capital gains. It's important for property owners to understand these concepts to accurately estimate their tax liabilities upon sale.

CHATGPT: Let's run through the calculations for your scenario, where a home was bought for $500,000 and sold for $800,000, with selling costs at 6.25%. The process of subtracting the land value is indeed a standard procedure in real estate accounting, particularly for depreciation purposes. Determining the land value can be a bit tricky, but it's often estimated as a percentage of the total property value or based on tax assessments or appraisals.

Here are the steps for your scenario:

1. Initial Purchase Price and Sales Price
   • Purchase Price: $500,000
   • Sales Price: $800,000
2. Calculating Selling Costs
   • Selling Costs = 6.25% of $800,000 = $800,000 × 0.0625 = $50,000
3. Net Sales Price After Selling Costs
   • Net Sales Price = Sales Price - Selling Costs = $800,000 - $50,000 = $750,000
4. Determining Land Value
   • For this example, let's assume the land value is 20% of the purchase price (this is an estimation; the actual percentage can vary).
   • Land Value = 20% of $500,000 = $500,000 × 0.20 = $100,000
5. Calculating Depreciable Basis (if applicable)
   • Depreciable Basis = Purchase Price - Land Value = $500,000 - $100,000 = $400,000
6. Calculating Depreciation (if applicable)
   • If the property was used as a rental, you would calculate annual depreciation. Assuming straight-line depreciation over 27.5 years, Annual Depreciation = $400,000 / 27.5 = $14,545 (approximately)
7. Total Accumulated Depreciation (if applicable)
   • If you held the property for, say, 10 years as a rental, Accumulated Depreciation = $14,545 × 10 = $145,450
8. Adjusted Basis (if depreciation applicable)
   • Adjusted Basis = Purchase Price - Accumulated Depreciation = $500,000 - $145,450 = $354,550
9. Calculating Taxable Gain
   • Taxable Gain = Net Sales Price - Adjusted Basis = $750,000 - $354,550 = $395,450
10. Tax Implications

• The taxable gain will be split into depreciation recapture (taxed up to 25%) and capital gains (taxed based on long-term capital gains rates).

Note: If the property was not used as a rental, then depreciation and adjusted basis calculations are not relevant, and the gain would simply be the difference between the net sales price and the original purchase price.

Regarding the determination of land value, it's common in real estate to allocate a portion of the total purchase price to the land. The exact percentage can vary based on several factors like location, type of property, and market conditions. Often, property tax assessments provide a breakdown between land value and building value, which can be a useful reference. If such details are not readily available, consulting with a real estate appraiser or a tax professional can provide more precise guidance.

NOTE:

When you sell a rental property, the IRS requires you to recapture any depreciation that could have been claimed, whether or not you actually claimed it. This means that even if you forgot to claim depreciation on your rental property each year, the IRS will still assume that you took the depreciation deductions when calculating the gain on the sale of the property.

Given this, the tax implications would be the same in both scenarios (whether you claimed the depreciation or not) because the IRS will calculate the depreciation recapture based on the depreciation that could have been claimed.

So, to correct my previous response, there would be no difference in tax liability between claiming and not claiming depreciation. The IRS treats the situation as if you had claimed the depreciation regardless. This is an important aspect of real estate taxation and highlights the need for property owners to be aware of depreciation rules and their impact on taxes when selling a property.

If a rental property owner does not claim depreciation on their property over the years, the primary loss they incur is the missed opportunity to reduce their taxable income annually. Here's what they lose:

1. Reduced Taxable Income: Depreciation is a non-cash expense that reduces taxable income from the property. By not claiming it, the owner pays more in income taxes each year because they are reporting higher net rental income.
2. Tax Savings: The reduced taxable income due to depreciation can result in significant tax savings over the years. The exact amount saved depends on the owner's tax bracket, but generally, the higher the bracket, the more significant the savings.
3. Cash Flow Impact: The tax savings from depreciation effectively increase the property's cash flow. Without claiming depreciation, the owner misses out on this improved cash flow, which could be used for other investments, property maintenance, or personal expenses.
4. No Benefit at Sale: As we discussed earlier, the IRS assumes depreciation was taken when calculating the capital gains and depreciation recapture tax at the sale of the property. So, the seller faces the same tax liability whether they claimed the depreciation or not. This means they miss out on the annual tax benefits without any corresponding reduction in tax liability upon sale.
5. Lost Cumulative Benefit: Over many years, the cumulative benefit of depreciation can be substantial. Not claiming it means losing out on this cumulative tax-deferred benefit.

By not claiming depreciation on the rental property over a 10-year period, the total tax savings lost, assuming a 24% tax bracket, would be approximately $34,909. This amount represents the additional taxes paid due to the higher taxable income reported each year without the depreciation deduction. Keep in mind that this is a simplified calculation and actual tax rates and circumstances can vary.