Are you thinking about selling real estate property? Are you liberal minded about selling your real-estate or more conservative? There are a number of issues that could impact the taxes that you might owe. Here are steps you can take to minimize the gain, defer the gain, or spread the gain over a number of years. Whichever you chose, you can win from the sale of your real estate, IF you handle it correctly.
The first and possibly most important issue is adjusted basis. It is an accounting mechanism to compute the gain or loss from the sale of property. What does this mean? Your gain or loss would be the sales price minus the sales expenses and adjusted basis.
Determining adjusted basis can be complicated. Here is a simple overview: it is a dollar amount that starts with your acquisition value. It is then adjusted up for improvements to the property, down for depreciation taken on the property, and down for any casualty losses claimed on the property.
The acquisition value is usually the price you paid for the property. It can also be the fair market value of an inheritance at the date of the decedent’s death. Another example is in the case of a gift, the donor’s adjusted basis at the time of making the gift.
As you can see, it is extremely important that you keep track of your basis; it is a key factor to determine gain or loss when you sell the property. Failure to keep a record and substantiating documentation could cost you dearly in income tax.
Passive Loss Carryovers
What if the property was a rental? In this case, the rental property that keeps losing money, the losses are not fully deductible. Meaning, in the year of the loss because of the passive loss limitation rules. So, in this case, you will have a passive loss carryover. Passive loss carryovers can be used to offset the gain. In addition, if you have other properties with passive loss carryovers you can use those properties to offset any gain from selling a rental property. Pretty helpful information, don’t you think?
Next, you have to decide whether you want to take all the income in one year or whether to attempt to spread the income over a period of years. For example, (i.e., report on your tax return) with an installment sale (by carrying back a loan) or defer the income into a replacement property through a tax-deferred exchange.
In an Installment Sale, the Seller is the Lender to the Buyer.
So, you are thinking selling real estate as an installment sale, are you? That can entail holding the first trust deed or taking back a second trust deed for only a portion of the loan amount. However, second trust deeds are as the name implies. If the buyer defaults on the loan, these second trust deeds are next in line for payment. Second trust deeds are riskier.
When set up as an installment sale, you report part of the gain for each year you receive payments. Generally, this is capital-gain income. In addition, the interest that the buyer pays the seller is taxable as ordinary income to the seller. Please note that installment sales are set up as short-term or long-term loans. Keep in mind, the buyer can always pay off the loan early or refinance. Either of these actions can make the balance of the profit from the sale taxable at that time.
Can I Defer the Gain Down of the Real Estate Sale? Is that Tax-Deferred Exchange?
The answer is yes. Income property held for investment, or is part of a trade or business, deferring the gain down the road is an option. This is done by using the rules of IRS Code Section 1031, which allows the taxpayer to acquire like-kind property. The owner defers the gain into the replacement property. This real estate property must be for business use or be held for investment and the rules for like-kind exchanges are complicated. They have strict timing issues, and require advance planning with a professional familiar with Section 1031 rules.
Tax on Net Investment Income
Adding complications to the sale-planning issue is the surtax on net investment income. So when selling real estate, take this into consideration. This 3.8% additional tax kicks in when a taxpayer’s modified adjusted gross income (MAGI) exceeds $200,000 ($250,000 for married joint filers and $125,000 for married individuals filing separately). The MAGI inclludes the gain from the realty sale. It could cause the MAGI threshold to exceed the threshold the IRS set. This will result in the surtax applying to some or all of the realty gain. However, you can minimize or even eliminate it by using an installment sale and spreading the gain over a number of years or deferring down the road with a tax-deferred exchange.
If the real estate is your home (primary residence), there are special rules. First, do you own and occupy the home two out of the five years prior to the sale? If so, you will be able to exclude a substantial portion of your gain. The tax-deferred exchange rules do not apply to personal-residence sales.
Need Help Facing That Huge Gain from Selling Real Estate?
So, facing that huge gain from selling real estate can be overwhelming. It can also get you into trouble. As you can see, the result of selling real-estate property can include a number of tax issues. You may wonder how minimizing current taxes requires some careful planning. Please call Alex Franch, BS EA at 781.849.7200 for assistance in planning your real-estate transactions. Worthtax has locations in Quincy, Weymouth and Dedham.
Tax Sources and Resource for Selling Your Property
- Thinking of Converting Your Home to a Rental? Read this First
- Installment Sale is a Useful Tool to Minimize Taxes
- Tax Break for Sale of Inherited Property
- How to Interview an Accountant