Calculating Gain on Real Estate Sale

Carrying back a loan on property you sell can be a wonderful way to make deals happen, sometimes the only way to make a deal happen, and provide a nice source of cash flow for years to come. While this can be a great way to take profit on a rental property and carry it over a number of years, it also can get you stuck in a tax trap if used under the wrong circumstances. Here's a guide to understanding when it is useful or detrimental to utilize installment sales.

So I sold a house... what will I owe the IRS?

How much profit did you actually make?

Profit is king. How much you have as gain on a house has nothing to do with appraisals or mortgage balances and everything to do with how much cash profit you have made on the deal. Let us take a simple example, you buy a house for $100,000 put an extra $30,000 into it then sell the house for $200,000. You had an additional $12,000 in real estate commissions and another $8,000 in closing costs on both ends of the sale, leaving you with $50,000 in taxable profit.

How much tax will I pay?

This is the million dollar question, and how I got into taxes in the first place when nobody could answer this question for me. As this is an article, not a book, there are other elements that come into play, but here are the basics. It is important to note that regardless of the class of income it can raise your gross income and bring you into a higher tax bracket, making other sources of income taxed at higher rates too. So it is a good idea to take your overall tax situation into consideration while figuring this out, not just looking at what a single deal will cost. Keep in mind that passive income, like sales of rental properties or rental income, also can be subject to the Net Investment Income Tax, which can add an extra 3.8% tax on top if you fall into the income bracket where this is an issue.

Are you in the Rental or Resale business?

This is the key question. If you are renting the property, holding it for a long period of time, and gaining from the market going up, you are primarily in the rental business. If you are buying property, improving it, and turning it around for a quick sale, like the house flippers on the TV shows, then you are in the resale business. Why is this important? If you are in the rental business then your real estate is considered a capital gain. If you are in the resale business then this is considered self-employment income.

How does this differ tax-wise?

For most taxpayers who are in a 25% tax bracket, capital gains are taxed at 15%, and this is the rate that applies for the sale of a rental property. For a resale property though this will be taxed as ordinary income at 25%, plus subject to 15% self-employment (social security and medicare) tax, making up a whopping 40% tax rate! There is a big difference between 15% and 40% tax rates.

But what if I refinanced the property and the sale barely pays off the mortgage?

If you refinanced a property and pulled cash out there is no tax due at the time of refinancing, but when you sell the property the total amount of gain on the property will be taxed. For example, let's say you bought that same house in the earlier example, but refinanced it for $150,000 a couple years ago and pulled out the $30,000 you had invested plus another $20,000. When you sell the property you will still owe taxes on the full $50,000 even though the cash proceeds received are only $20,000.

The depreciation recapture trap...

None of these examples take into account depreciation recapture which can be a hefty tax burden even when your sale is classified as a rental. If you have owned a rental property for a number of years you will be hit with recapture of depreciation, and this applies to depreciation allowed or allowable! Rental houses are depreciated over 27.5 years using a straight line method. So, using the example above, if you rented that $130,000 house for three years you would have depreciated it $14,182. This amount will be recaptured at ordinary income tax rates, which at a 25% rate comes to $3,545 in tax.

Are there any other options?

Luckily, real estate has a couple extra options that with a little bit of planning can minimize the impact of taxes on growth of your investment. 1031 Exchanges can be a good way to defer gains by reinvesting the funds from the sale directly into a new purchase of real estate. If the gain is high in the year of sale and that may cause tax troubles, it also is possible to sell using an installment sale that can create a good source of income over coming years while also minimizing tax impact in any particular year.

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