Understanding Gains Tax and How to Calculate It
Austin Bowlin, CPA – Partner at Real Estate Transition Solutions Even in the most robust seller's market, there is one thing that gives an investment property owner pause: capital gains taxes. And as an Oregon investment property owner, your tax liability on the sale of investment property can be substantial – as much as 37.7% - driving many investors to explore tax-deferral strategies like a 1031 Exchange.
A Closer Look at Tax Liability
As a licensed 1031 Exchange Advisor, one of the first things we do when working with a client is to help them understand their tax liability. Tax liability from the sale of investment real estate is not just about federal capital gains tax – it is the total aggregate amount of tax owed when an investment property is sold. Not only are you responsible for Federal Capital Gains Tax (15% - 20%), but you may also have to pay State Capital Gains Tax (0-13.3%), Depreciation Recapture Tax (25%), and Net Investment Income Tax (3.8%).
How to Calculate Tax Liability
Federal & state tax authorities calculate the amount you owe based on the taxable gain, not the gross proceeds from the sale of the property. To estimate the total tax liability after the sale of an asset, follow these five steps: Step 1: Estimate the Net Sales Proceeds Start by determining the fair market value of the investment property or the list price if you brought the property to market. There are several ways to calculate the sales price, but the most popular are the income method and the comparable sale method. Smaller properties and single-family rentals typically rely on the comparable sales method, while larger properties rely on net operating income to determine value. For example, let us assume a comparison of similar local properties indicates a property may sell for $3,500,000 with $250,000 in deductible selling costs such as brokerage costs, title, escrow, and excise tax (if applicable). In this scenario, the net sales proceeds would be $3,250,000. Importantly, the net sales proceeds do not consider any loan balances paid off at closing. Step 2: Estimate the Tax Basis Tax basis, also known as remaining basis, is the total capital that an owner has invested and capitalized in the investment property, including the purchase price, closing costs, and capitalized improvements minus the accumulated depreciation. For example, if you purchased the property for $850,000, invested $200,000 in capital improvements and have $750,000 in depreciation, your remaining basis is $300,000. There are some limitations to the items that you can include in the tax basis. Mortgage insurance premiums and routine maintenance costs are examples of items that are not included. A tax advisor can help to determine your property’s current remaining basis, which can be adjusted based on capital improvements and tax deductions. •Increasing the Tax Basis: Property owners will increase www.rhaoregon.org
their tax basis anytime they invest money into the property with capitalized improvements—such as a new kitchen, roof, or even an addition, as well as financing expenses. Expenses paid to operate the property, like legal fees, management expenses, and small repairs are not capitalized and instead treated as operating expenses. Capitalized improvements increase your investment in the property and are deducted from the net sales proceeds at the time of the sale to arrive at the property’s gain. While some of these costs are intrinsic to real estate investment, like escrow fees, others are flexible. A new roof, an upgrade to the kitchen, or adding a pool are capital improvements that have a wide range of costs, giving the owner some flexibility in the amount they can increase the tax basis of the asset versus deduct in the current year as an operating expense. •Decreasing the Tax Basis: Owners of investment real estate that include a building or structure must also decrease the property’s tax basis, ultimately increasing the figure used to calculate the second form of gain referred to as “depreciation recapture”. The most common way to decrease the tax basis is through an annual depreciation deduction. The deduction is subtracted from the tax basis on an annual basis to be treated as a tax expense offsetting income which is then recaptured at the time of sale. While it might seem unexpected to decrease your tax basis and eventually increase your tax costs, the depreciation deduction reduces an investor’s annual taxable income and thus income tax due during the years of ownership. Note that annual depreciation is not optional. Investors will be charged for depreciation recapture on the aggregate amount of available depreciation throughout the period of ownership regardless of whether they recorded depreciation expense. Easements, some insurance reimbursements, and other tax deductions, like personal property deductions, can also decrease your tax basis. Step 3: Calculate Taxable Gain The taxable gain is the realized return or profit from the sale of an asset, or, in other words, it is the net sales proceeds less the original tax basis, pre-depreciation. Tax authorities like the IRS and Franchise Tax Board use the taxable gain figure to determine the capital gains tax. To calculate the taxable gain, subtract the original tax basis from the net sale proceeds. Using the earlier example, if your original tax basis is $1,050,000 and the net proceeds from the sale of the property is $3,250,000, your taxable gain is $2,200,000. The second part of the tax liability is calculated based on the amount of depreciation available to take over the period of ownership – referred to as accumulated depreciation. Based on the above scenario, this amount is $750,000. Step 4: Determine Your Filing Status Your income, tax filing status, the
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RENTAL ALLIANCE UPDATE April 2021
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