Our last article on real estate investment focused on the passive activity loss rules but there are other tax implications to being a landlord that should be considered in addition to this. A main concern for investors in real estate not held for personal use is exit strategies and the tax impact of selling their investment property. When selling investment real estate there are a few different scenarios that can occur:
- “I sold my investment property at a loss, how is this going to impact me?”
If your investment in real estate does not generate the return that you were hoping for, there is a silver lining – you will be able to deduct the losses against your ordinary income. Real property has specific carve outs in the Internal Revenue Code that offer preferential treatment compared to investments in securities. Normally if an investment is sold at a loss it is subject to the capital loss limitations which allow capital losses to the extent of capital gains plus $3,000.
- “I sold my investment property for the price I paid for it, what is going to happen next?”
In this situation there will likely be a capital gain recognized on the disposition of your real estate investment. This occurs due to depreciation recapture rules related to real estate. These gains are treated as capital gains and can be offset by losses on dispositions of other property used in a trade or business. The highest tax rate that these gains can be subject to is 25%. If there is ordinary income assets within the property, you may be subject to ordinary income recapture at a rate of up to 37%. There is a silver lining here as well though, it is not uncommon that passive activity losses will have been limited in prior years. In most cases, a large contributor to the passive activity losses is due to depreciation so the limited prior year losses may closely align with the depreciation recapture. Once the property is completely disposed of, the passive activity losses will be released which will offer a deduction against ordinary income. Additionally, all expenses related to the sale of your property will reduce the gain realized on the transaction.
- “I sold my investment property for a gain, how much tax am I going to end up owing due to this transaction?”
This is the ideal scenario for investors in real estate and what we see most often if the property is held over a longer timeframe. Similar to situation #2 above, there will be depreciation recapture on this transaction that will be treated as a capital gain subject to a maximum tax rate of 25% and potentially ordinary income recapture subject to a maximum federal rate of 37% if there are ordinary income assets being sold in addition to the real estate. The gain that is a result of appreciation on the property will also be treated as a capital gain, similar to gains on the sale of securities. Capital gains are subject to preferential tax rates compared to ordinary income. For married filing joint taxpayers in 2023 the following rates will apply:
| Capital Gains Tax Rate | Taxable Income Threshold |
| 0% | Less than $89,250 |
| 15% | Between $89,251 and $553,850 |
| 20% | Greater than $553,850 |
For taxpayers who are married filing jointly, if the modified adjusted gross income is in excess of $250,000 then they will also be subject to the 3.8% net investment income tax.
When structuring transactions to dispose of a real estate investment, there are strategies available to taxpayers that allow gain to be deferred. Two of the most common strategies are installment sales and like-kind exchanges (commonly referred to as §1031 exchanges due to the Internal Revenue Code section that governs these transactions).
Installment Sales
An installment sale occurs when a seller finances the acquirer’s purchase and holds the note on the sale. In this scenario, any component of gain on the disposition that is ordinary will be recognized in the year of the sale but the capital component will be recognized as the loan principal is collected. There is also an interest income component on these transactions. This is a powerful tool to defer gain if the seller does not need access to the capital from the sale in the near term and there isn’t a large portion of the sale that will result in an ordinary gain. The deferral of the gain is beneficial if the taxpayer expects their income to decrease during the time period of the loan as it may allow for lower overall income tax rates on ordinary income as well as capital gains tax rates.
Let’s look at a simplified example of how capital gain is recognized on an installment sale. A taxpayer sells real estate on January 1st for $1,000,000 and realizes a capital gain $500,000 on the sale, 50% of the proceeds from the sale are capital gain. They hold a note for $800,000 to be collected over ten years, we will ignore interest and assume that principal is being collected evenly over the life of the loan for this example. In the year of the sale the taxpayer will realize a capital gain of $140,000 as a result of collecting the down payment of $200,000 at the point of sale and $80,000 on the loan over the course of the year. In the following years, only $40,000 of capital gain will be recognized until the loan is paid in full. If the transaction were financed by another third party or was paid in cash at the time of the sale then the entire $500,000 gain would be recognized.
1031 Like-kind exchange
Like-kind exchanges are a powerful tool for real estate investors who are looking to either pivot from their current holding or who are looking to scale their activity. If a §1031 exchange is properly executed, no gain is recognized on the sale of real estate. This allows the taxpayer to invest the entire amount of net proceeds from the transaction into new real estate. The basis of the new property is adjusted by the gain that is deferred on the old property in these transactions and will be recognized once that property is disposed of unless another §1031 exchange is done. There is downside to §1031 exchanges though, such as but not limited to:
- Tying up capital in new real estate, does not allow the taxpayer to extract capital from the sale without recognizing gain.
- Higher transactional costs, a Qualified Intermediary must be used to execute the transaction.
- Replacement property needs to be identified within 45 days of the sale and needs to be purchased within 180 days of the sale.
When planning to dispose of investment real estate not held for personal use, it is important to know all of the tools that are available to minimize the tax burden. Depending on a taxpayer’s attributes and overall financial plan, deferring the gain may not always result in the best outcome. If you are planning on disposing of a real estate investment, BS&P CPAs and Consultants has a team of experienced advisors to assist in determining the best structure for this transaction.
Written by Matt Sova, Manager