Tax on Selling a Rental Property Explained
By Rick Torkelson, CPA and principal of Torkelson & Associates, CPAs, LLP in Petaluma, CA
We recently demonstrated how to compute a gain on the sale of a rental unit that we purchased, rented to tenants for 10 years and then sold.
Here is a summary of the rental home situation:
We put down $100,000 and financed $300,000. Our out of pocket rental expenses equaled our rent income. We made payments on the $300,000 mortgage for 10 years. After 10 years of payments, the balance of this loan would be about $244,000. We wrote off $11,000 of depreciation every year for 10 years saving us about $22,300 in taxes over those 10 years. We sold the property after 10 years for $550,000 paying $27,500 to sell it. The taxable gain on the house was $232,500 (all long term capital gain) and the income taxes on our gain was $56,500.
Here is a recap of the cash we have after these facts:
Sales Price: 550,000.
Commission: <27,500>.
Pay-off Loan: <244,000>.
Cash After Sale 278,500.
Income Tax: <56,500>.
Net Cash After Tax: $222,000.
What can be done besides putting $222,000 in the bank? Assuming you don’t want to buy another house, one option is to sell the house – and pay the income taxes – on an installment basis.
Sale of Your Rental Property on Installment Basis
Rather than closing the escrow and banking the cash, let’s say you tell the buyer that you will take back a note from him for $200,000. This means he needs $200K less cash or needs to borrow $200K less from a financial institution to buy the house. To pay back this 200K note, you ask for 7% annual interest and monthly payments of $1,800 per month. This will pay the loan off in 15 years.
The advantage here is that you now have a nice monthly income, you are earning 7% interest all along the way, secured by the real property you sold. Over 15 years, you will collect $324,000 on you $200K loan.
But what about the tax? The simple theory here is that on the installment basis, you pay your taxes as you collect your principal. The first step is to compute the total money you will collect in this transaction – this is called the “contract price”. In this example, the contract price is $306,000 computed by subtracting the $244,000 mortgage you owed when you sold the house from the $550,000 sales price. Next step is to develop the “Gross Profit Percentage”. This is done by dividing the taxable gain $232,500 by the contract price $306,000 to get 75.98%. This percentage carries over year after year. Each year, you take the principal you collect from the sale (or note), multiply it by 75.98% to determine the taxable income from the sale.
Since you are carrying back a note for $200,000 this means that you will be deferring the tax on $151,960 ($200,000 X .7598) of the income and will pay tax on this amount as the note payments come in over 15 years. All this is done on IRS form 6252.
The advantages are that financing part of the sale makes it easier for many people to buy your property. You typically get a greater return on your investment, 7% in my example, than you would typically get at a bank. And you get to stretch out the income taxes over several years – 15 years in my example.
Disadvantages are that the buyer may default on the note. This is only a major problem if you take very little down payment, the property drops in value and the buyer defaults almost immediately. Another possible disadvantage is that the capital gain rate you pay each year depends on the tax law in the year you collect the principal. Although capital gains have always been a tax favored gain, there is no way to know the capital gains rates in the future.
Reminder
Again – Do your tax planning soon. If you’ve had an unusual year, the best way to avoid surprises is to project your taxes now – when there’s time to do something about them.
Sale of Your Rental Property on Tax Deferred Exchange (1031 Exchange) Basis
We demonstrated how to report a gain from the sale of our property rental in the installment basis. Now, we will show the tax effects of a Tax Deferred Exchange AKA 1031 exchange – named after the IRS code section with all the rules.
Here is a summary of the tax situation:
To purchase the rental, we put down $100,000 and financed $300,000. Our out of pocket rental expenses equaled our rent income. We made payments on the $300,000 mortgage for 10 years. After 10 years of payments, the balance of this loan would be about $244,000. We wrote off $11,000 of depreciation every year for 10 years saving us about $22,300 in taxes over those 10 years. We sold the property after 10 years for $550,000 paying $27,500 to sell it. The taxable gain on the house was $232,500 (all long term capital gain) and the income tax on our gain was $56,500.
Here is a recap of the cash we have after these facts:
Sales Price: 550,000.
Commission: <27,500>.
Pay-off Loan: <244,000>.
Cash After Sale: 278,500.
Income Tax: <56,500>.
Net Cash After Tax: $222,000.
What is a Tax Deferred Exchange?
Exchanges are not for everyone. Whenever one of my clients is selling a property and asks me if there is anything they can do to lower the tax, I ask them “When the escrow closes, what do you plan to do with the money?” If their answer is to buy another property, then an exchange just might work beautifully.
You don’t get any cash or pay off any debt when you exchange unless you are prepared to pay tax on the cash and the reduction of debt. What you do get is the ability to put all your proceeds into another property without the erosion of income tax.
Yes all the taxes on a sale like the one illustrated above can be deferred, but it is a deferred exchange, not a tax free exchange. To completely avoid the taxes in the year of sale ($56,500 in our example), you must buy a property for at least your sales price less your sales expenses $522,500 (550,000 less 27,500) in my example.
One scenario that comes up from time to time is “I’ll buy a cheaper property with all my proceeds, $278,500, and not have any payments.” This is a disaster – All your proceeds went into the new property, but your $244,000 mortgage is gone – This scenario will tax the entire gain, $232,500, and you will have no cash from the sale to pay the tax. Reducing your debt is taxed just like getting cash out of the sale.
Additional Considerations with a Home Tax Deferred Exchange
It is critically important you do not have access to your sales proceeds during this entire exchange. To accomplish this, you must use a professional “exchanger” or “facilitator” to make this exchange. You must have your exchange property identified within 45 days from the sale of your property and you must close the target property within the earlier of the due date of your tax return or 180 days.
I keep writing tax deferred exchange – this has to do with basis or cost of the new replacement property. If an exchange is accomplished where the entire gain ($232,500 in our example) is not currently taxable, the cost of the new replacement property is affected. Simply stated, what the IRS rules require is that you must subtract the untaxed gain ($232,500 in our example) from the cost of the replacement property. If the property really cost 600,000, then for tax purposes, it costs $367,500 (600,000-232,500). And it is $367,500 that we depreciate and report as cost of the property if it is ever sold.
The very best thing you can do is to consult with a tax professional before you put your rental property on the market.