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Tax Planning: Facing A Huge Gain from a Real Estate Sale?

by
Keith Vincent
on
9/30/2015
Tax Planning: Facing A Huge Gain from a Real Estate Sale?

When you own real estate and are anticipating selling it at a profit, you should also anticipate that you may end up with a significant tax burden. Understanding the ways that gains and loss are calculated on the sale of property can help you to minimize your tax exposure. Through strategic accounting you can minimize or defer the gain, or even account for it over a period of years.

Much of what you need to understand before accounting for a real estate sale revolves around the issue of adjusted basis. Adjusted basis is the amount of money that the property originally cost, adjusted up for any improvements that you make and down for depreciation. Additionally, the adjusted basis will reflect any casualty losses such as the effects of fire or storm damage. The gain or loss that you show when you sell a piece of property starts with the adjusted basis. The calculation begins with the price that you sell the property for, then subtracts the adjusted basis and any other expenses related to the property's sale.

Keeping track of adjusted basis is extremely important, and has to begin from the time that you acquire the property. This can be complicated: it may be easy to know the adjusted basis for a property that acquired through a purchase, but if you inherited the property then you need to know the fair market value at the time of the decedent's death, and if you received it as a gift then you need to know what the adjusted basis was for the person who gave it to you, when they gave it to you. Investigating and recording this information at the time of acquisition and then keeping track of all expenses over the time that you own the property is of great value, and failure to do so can end up costing you more than you deserve to pay in taxes.

Beyond the calculations cited above, specific types of properties may have additional losses that can be deducted for tax purposes. For example, rental properties that operate at a loss may not have been deductible in the year that the loss occurred as a result of passive loss limitation rules, but these can be carried over at the time of sale in order to offset gains. If you own multiple rental properties, any passive loss carryovers on them can also be applied in order to reduce your overall gains.

Taxpayers who are selling a property at a gain have additional ways of reducing their tax obligation. There is always the option of carrying the buyer's loan and accounting for the sale as an installment sale rather than a straightforward sale of the property which requires reporting the gain in a single tax year. As the seller, you can also defer the income through a tax-deferred exchange into a replacement property.

If considering an installment sale and acting as the lender for the new buyer, it is important to understand that you will be holding the first trust deed, or in some cases only holding a portion of the loan amount as a second trust deed. There is risk involved in pursuing the latter course of action; as the holder of the second trust deed, the seller is by definition second to the original lender for payment, and therefore at greater risk in a default. If, however, you make the decision to carry the entire loan you will be able to report your gains as capital gain income as the payments are received. Any interest that you receive from the buyer is taxable, and the sale can be structure for whatever length of time you prefer, either short-term or long. There is always the risk that the buyer will make the decision to pay off the loan all at once or refinance, which will leave you owing the taxes on the balance of the loan all at once.

Many sellers opt for holding onto a property as an investment, or deferring the gains by trading it or using it for business purposes. This is called deferring the gain into a replacement property, and is covered under IRS Code Section 1031. This particular strategy can be extremely complex, as it involves rigid deadlines. It is advised that those considering taking advantage of this option do so with the help of a tax professional. 

It is essential that while devising a strategy for real estate property sales, individuals remember that there is a 3.8 percent surtax on net investment income that comes into play when a taxpayer's modified adjusted gross income (MAGI) is over $200,000. For married joint filers this number is $250,000, and married individuals who file separately encounter this tax at a threshold of $125,000. The calculation of the MAGI includes gains on realty sales, and could be the difference between not reaching the threshold and exceeding it. This issue can be addressed through the use of an installment sale or tax deferred exchange, both of which spread the gains over a period of years or defer them until a later date.

Finally, selecting the right strategy for avoiding taxation in the sale of real estate depends upon whether the property in question is your primary residence. There are special rules that apply to selling your home – these state that if you have both owned and occupied the property for two out of the five years prior to selling it, much of the gain that is realized can be excluded. However, the same personal residence rules also exclude the use of the tax-deferred exchange option. 

Minimizing your tax burden when selling real estate property can be a complicated process that requires expertise and foresight.

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Keith Vincent

Keith Vincent

Ken Riter is a Certified Public Accountant based in Holladay, Utah. He is a graduate of the University of Utah and brings broad financial and tax preparation experience to bear for each of his clients. With strong computer systems experience, Ken has empowered many business clients to gain better control of their finances by utilizing the power of the computer. His years of tax planning and tax preparation experience give his clients a distinct advantage in their tax needs. Starting in Salt Lake City, our company history is built on a tradition of service, technical expertise, and innovative thinking to meet the needs of a rapidly changing world.

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