This updated excerpt from the forthcoming edition of Tax Benefits of Ownership covers the basics of profit reporting on the sale of real estate, including long-term and unrecaptured gains.

The batching and taxing of gains 

Income tax knowledge by real estate agents is an engaging tool for assisting clients with their decision to sell a property they do not want to own. Specifically, an agent’s tax knowledge passed on to clients becomes business goodwill, an indicia of the agent’s brand. In turn, the earning power of goodwill generates further employment by members of the public, i.e., superior listings, larger dollar transactions and expanded clientele.

Counseling a client on the tax aspects of a sale, purchase, or reinvestment in the early stage of an agency relationship typically excites an ongoing tax discussion. Tax consequences are of constant concern to all participants in real estate transactions – a material fact grooming their decisions.

Of course, the objective of a discussion on taxes is to achieve the most favorable tax result available to the client without altering the financial underpinnings and risks deemed acceptable in a sale (or purchase). While material, tax consequences is the least important in the hierarchy of fundamentals when making decisions in a real estate transaction.

The earlier in the client relationship an agent begins the tax discussion, the likelier the client will consult with other competent professionals about their agent’s tax-related discussions. The agent’s discussion becomes the focal point influencing the client’s conversations with other advisors, professional or otherwise.  A client’s early consultation with others allows the client to follow up on their agent’s advice, such as a carryback sale or the purchase of replacement property in a §1031 reinvestment plan, or as here, the magnitude of unrecaptured and capital gains taxes.

Encouraging a client to discuss the transaction with other advisors available to the client – or the client authorizing the agent to do so – results in increased coordination between the client and agent.

When a client involves other professional advisors, the agent’s duty of care owed a client is not relinquished to their other advisors. The agent’s duty is to present their client with information about a transaction the agent believes may impact the client, information the client needs to consider when making decisions. The agent’s counseling might well be contrary to advice given to the client by others, such as the client’s attorney or accountant, which then needs to be resolved. [Brown v. Critchfield (1980) 100 CA3d 858]

Although an agent’s opinion is not conclusive, it is relevant and important. Further, agents negotiating a transaction need to maintain influence over client decisions so the client’s goals known to the agent are attained. Changing market conditions and the innuendos and nuances of real estate negotiations are best known and managed by agents. Agents are regularly involved in real estate transactions and their clients are not.  Agents are likely more often involved than the client’s other advisors. Also, agents giving advise routinely develop professional relationships with individuals from other professions who will remember the agent long after the transaction is closed.

Finally, an agent’s failure to coordinate activity in a transaction with the client’s other advisors can prove detrimental for the agent. An agent who persuades a client to rely on their advice to the exclusion of contrary (and correct) advice of other professionals is liable for any losses suffered by the client due to the agent’s unsound advice. It is best to let the client sort out all the advice they receive (including the agent’s) and make their own decision regarding whose advice to follow. [In re Jogert, Inc. (1991) 950 F2d 1498]

Disclosures benefit the agent

As most agents and sellers know, the sale of every parcel of real estate, except dealer property, produces a profit (or loss as the flip side of that coin) for a seller when the price exceeds the seller’s cost basis in the property.  And agents know a sale at a price above the cost basis produces a tax liability.

However, an agent handling a one-to-four unit residential property is not obligated to mention tax consequences or disclose any part of their tax knowledge to their buyers or sellers of this class of properties. The exculpatory provisions in the state mandated agency disclosure law eliminate any duty to affirmatively disclose the tax aspects in one-to-four unit transactions. This permissive non-disclosure is part of the dumb-agent rules for one-to-four unit sales dear to large SFR brokerage operations. [See RPI Form 305]

However, an agent with knowledge of the tax aspects of real estate transactions does not leave their buyer or seller to their own devices, not even on one-to-four residential units. Consider that an agent’s interests are best served when they assist their client by:

  • giving tax advice on the transaction to the best of their knowledge;
  • disclosing the basis for their opinion as the advice given;
  • encouraging (or requiring) the client to consult other advisors about the tax advice given; and
  • conditioning the transaction on the client’s right to cancel the purchase agreement by including a further-approval contingency provision regarding clearance of the transaction’s tax consequences.

INTAX for disclosing tax consequences of a sale 

Before entering into a tax discussion with their seller about a proposed sale, the agent needs to think through the preparation of an Individual Tax Analysis (INTAX) form for review with the seller. By using it, the agent breaks down the profit taken on a sale into the two types of gains, called batching. Without first batching the gains, the agent is unable to develop an accurate estimate of the seller’s tax liability generated by closing a sale the agent negotiated. [See Form 351]

During a review of the profit tax liability estimated on the INTAX form, the agent needs to discuss variations for the client to consider on a sale to exclude or exempt profit from taxes or to defer profit reporting and taxes on the proposed sale.

Thus, the seller who initially sought only to “cash out” their ownership of real estate they no longer want, might consider a §1031 reinvestment plan and acquire a replacement property – with the agent’s assistance. Alternatively, the seller might see good reason to structure a sale as a carryback transaction. Thus, the seller retains the earning power of their profits, untaxed, until years later when the deferred profit from the sale is reported and taxed.

The top half of the INTAX form is a review of the seller’s taxable income and profit or loss. An agent needs the client’s estimate of their taxable income before they can estimate the profit tax on a sale. Further, the client’s estimated ordinary income is needed to determine how much of the client’s taxable income remains to be taxed at the lower unrecaptured and capital gains rates.

The profit review first takes place at the listing stage, and again when a purchase agreement offer or counteroffer is submitted and reviewed. The tax discussion with the seller on each occasion may be limited to the amount of profit on the sale, the batching of the gains, and any tax liability exposure due on those gains. Also, a seller who is a high-income earner is more likely to respond favorably to an agent’s tax discussion than a low-income earner.

Two formats for setting tax liability 

The INTAX worksheet contains separate columns for calculating the amount of profit taxes: one for the standard income tax (SIT) and the other for the alternative minimum income tax (AMT).

AMT rates can increase the seller’s tax liability on income from their business, professional, and investment sources. However, the distinction has no impact on the profit taxes incurred on the sale of a capital or business asset. The tax rate for gains (profit) on a sale remains the same for SIT and AMT no matter the amount of ordinary income and itemized deductions of a high-income earner.

Thus, an agent’s tax discussion with a seller of investment or business-use property is limited to the types of gains contained in the profit on the sale, and the tax due on those gains, not the SIT or AMT tax consequences. [See Form 351 §§5.3 and 5.4]

In contrast, the INTAX form is not used to assist a buyer of real estate on their selection of property based on the tax consequences of a purchase. The Annual Property Operating Data (APOD) sheet provides the depreciation schedule covering the only tax benefit available to a buyer during the buyer’s ownership and operation of their property. [See RPI Form 223]

Further, the increase or decrease in the buyer’s annual taxes brought on by the purchase of a property is calculated on a Comparative Analysis Projection (CAP) worksheet, not the INTAX form which is designed solely for sales. [See RPI Form 353 §5.3]

When a seller acquires like-kind replacement property in a §1031 reinvestment plan, they avoid profit taxes on some or all the profit realized on the property sold. In §1031 situations, the agent need only prepare a Profit and Basis Recap Sheet to calculate the profit tax the client avoids. [See RPI Form 354]

Occasionally, the seller’s §1031 reinvestment plan might qualify them for a partial §1031 exemption. Their withdrawal of cash, receipt of a carryback note, or a reduced amount of mortgage debt on the reinvestment causes part of the profit they realize to be taxed. Items withdrawn before acquiring all replacement property cannot be offset and the profit allocated to them is taxed. Here, the INTAX form section for batching taxable profit includes profit taxed in the partial §1031 transaction. [Internal Revenue Code §1031(b)]

Capital gain tax rate set by taxable income thresholds 

When the amount of the net sale price of business-use or investment real estate is greater than the price the seller paid for the property and improvements, the seller takes a capital gain as part of their profits.  Capital gains are broken down into either short-term capital gains when held less than one year and treated as ordinary income, or long-term capital gains when held for more than one year.

From a different analysis of profits, the net profit on a sale is the difference between the net sales price (gross price less transactional costs) and the seller’s remaining cost basis in the property sold (price minus basis equals profit).

Net profit is taxed, but at different rates from ordinary income, unless exempt, excluded, deferred, or reduced by offsets for losses and deductions.

Critically, net profit consists of two types of gain — unrecaptured gain and capital gain — each with different sets of tax rates and priorities for computing taxes on taxable income, specifically:

  • unrecaptured gain, represented by the accumulated amount of depreciation deductions taken on the property sold, is taxed up to the maximum rate of 25% [IRC §1(h)(1)(E); see Form 351 §5.3]; and
  • long-term capital gain, also called adjusted net capital gain, is the net profit remaining after subtracting unrecaptured gain, and is taxed at a single rate of either 0%, 15% or 20% set by thresholds applied to the seller’s taxable income. [IRC §1(h)(1)(C)-(D); see Form 351 §5.4]

Further, when the resale price is less than the price paid to acquire the property and make improvements (no capital gain is realized), the unrecaptured gain taxed is limited to the net resale price minus the cost basis.

For example, a couple selling a rental property paid $300,000 for the property. Their depreciation deductions total $100,000. The property is sold for $450,000, a profit of $250,000 over their remaining cost basis of $200,000. Critically, the couple’s taxable income for the year 2021 is between the $80,800 and $501,600 taxable income thresholds triggering the taxing of all capital gains in the couple’s taxable income at the rate of 15%. [See Form 351 §4]

 

The couple’s profit of $250,000 is broken down — batched — into:

  • unrecaptured gain, consisting of $100,000 in reported depreciation deductions, taxed at its ceiling 25% rate for a maximum tax liability of $25,000 [See Form 351 §5.3]; and
  • long-term capital gain, limited to the remaining $150,000 of taxable income, and taxed at the 15% rate for a maximum tax liability of $22,500.

The taxable income thresholds which set the single rate used to tax all capital gains are adjusted each year for inflation. [IRC §1(j)(5)(B)]

In the order of descending rates to reduce subsidies 

Here is presented a fuller picture of the effect on taxable income by including in these examples the seller’s ordinary income and personal deductions which limit the amount of capital gains to be taxed.

Typically the capital gain amount on a sale is greater than the portion of the seller’s taxable income allocated to capital gains and taxed. This result of a small amount of capital gains as taxed is due to priority treatment given to taxing ordinary income and unrecaptured gains, and personal or rental loss deductions. When capital gain amounts are greater than the amount of taxable income remaining after taxing ordinary income and unrecaptured gains, the capital gain rate simply applies only to the remainder of the taxable income.

Also, when capital gains are reported the personal deductions end up reducing the amount of capital gains remaining to be taxed, but not reducing ordinary income or unrecaptured gains which are taxed at higher rates (up to 37% and 25%) than capital gains (15% or 20%). Ordinary income is the first batch of taxable income to be accounted for and taxed.  When sales generate capital gains, any taxable income remaining untaxed after ordinary income and unrecaptured gains are accounted for is taxed at the capital gains rate. Capital gains exceeding the taxable income amount are ignored as untaxed due to offsets in setting the AGI and deductions.

Other types of profit exist in taxable income which are batched and taxed after accounting for ordinary income but before taxing unrecaptured gains. Profit on the sale of coins and art is called a collectibles gain. Collectibles are taxed up to a maximum rate of 28%, unless sold in a §1031 reinvestment plan as exempt. Profit on the sale of small business stock, called a §1202 gain, is also taxed up to a maximum rate of 28%. [IRC §§1(h)(4), 1(h)(5), 1(h)(7)]

Netting gains and taxing priorities

Recall that the total amount of all income, profits and allowable losses from each income category is called adjusted gross income (AGI). Subtracting personal and rental loss deductions from AGI produces the seller’s taxable income. [IRC §§63(b), 63(d)]

To determine the tax liability of the seller, taxable income is broken down into two major components for sellers of real estate:

To accomplish this breakdown of the taxable income, the net profits – gains – within each income category are added together.

Ordinary income is taxed at whichever produces the greater amount of taxes:

  • SIT rates ranging from 10% to a ceiling of 37%, or
  • AMT rates of 26% and 28%.

Batching gains for taxable income

To calculate the income tax on net profits from a sale, profits are broken down and batched into unrecaptured gain and capital gain. Then after taxing ordinary income in the taxable income amount at rate brackets up to 37%, profits are taxed by their type of gain in the order of descending rates, until no amount of taxable income remains to be taxed:

  • first, any collectibles gain and business stock gain, taxed at a 28% rate;
  • next, any unrecaptured gain, taxed at a maximum rate of 25%; and
  • last, any taxable income remaining untaxed is long-term capital gain taxed at either the 15% or 20% capital gain rate as set by taxable income thresholds. [See IRS Form 1041, Schedule D Part IV]

Earnings on the sale of dealer property, also called inventory, are reported as business income, not profit on the sale of assets. Recall that dealer property is held primarily for sale to customers of a business, not for productive use in a business or investment. [IRC §1231(b)]

The principal residence profit exclusion 

Profit remaining on the sale of a principal residence after taking the profit exclusion is reported as a short- or long-term gain (held, respectively, less or more than one year).

For example, a homeowner and spouse paid $250,000 for their principal residence which they are now offering for sale at a net sales price of $900,000. The homeowners did not take any depreciation deductions on the residence as a home office or as a rental, in whole or in part. Thus, their cost basis remains unchanged as the price they originally paid for the residence and additional improvements.

On the sale, they will take a profit of $650,000 since a principal residence is classified as a capital asset. They qualify for a combined exclusion from profit tax of $500,000. Thus, they have a reportable profit of $150,000 – a portfolio income category profit which in combined into their AGI, and after deductions, is part of the homeowner’s taxable income.

Further, the $150,000 in profit remaining (after taking their principal residence profit exclusion) will be reported as a long-term capital gain and taxed as remaining taxable income at the 15% rate after all other income is taxed. Their maximum tax liability on the sale of the residence is $22,500. [See Form 351 §5.4]

Conversely, a seller may not use a loss on the sale of the principal residence to offset investment or business category income or profits — it is an unsubsidized personal loss.

Carryback sale profit reporting 

Profit allocated to any note carried back by a seller is reported each year as payment is received. The profit allocated to the principal in the installment payments is also batched and reported in the year received. The profit allocated to the down payment and principal installments is taxed at the relevant rates. [IRC §453]

For example, real estate used to provide warehouse space for a seller’s distribution business is sold for the net sales price of $1,000,000. Terms include a $100,000 down payment, the buyer to assume or refinance a $400,000 mortgage and execute a $500,000 carryback note for the balance of the price. The seller has taken depreciation deductions of $150,000, leaving an adjusted cost basis of $500,000 at the time of sale. Thus, the profit on the sale is $500,000 (price minus basis equals profit).

As a result, the installment sale’s contract ratio of profit-to-equity ($500,000/$600,000) for the allocation of profit to principal is 83.3%. Accordingly, the down payment of $100,000 is 83.3% profit ($83,333) and the carryback note of $500,000 is 83.3% profit ($416,666), both amounts making up the total profit on the sale.

Further, by batching, $150,000 of the profits is unrecaptured gain (depreciation), to be taxed before calculating the tax for any long-term gain remaining in the taxable income. Thus, profit taxes are only paid when cash is received from the down payment, and from installments of principal.

The entire profit of $83,333 in the down payment is reported as unrecaptured gain and taxed up to the 25% ceiling rate. The remainder of the unrecaptured gain is reported on 83.3% of the principal payments and taxed when received on the carryback note, ending the year the unrecaptured gain is fully reported. All remaining profit (83.3% of the note’s principal balance) is taxed at the long-term capital gain rate as principal is received on the note. [See Form 351 §§5.3 and 5.4]

The alternative minimum tax on other than profits

For high-income earners, ordinary income tax needs to be calculated twice, once under SIT rates and again under AMT rates.

This is not so for profits, as the rate remains unchanged.

Whichever SIT or AMT calculation sets the highest tax liability, that amount is the tax paid on the ordinary income portion of the taxable income. [IRC §55(a); See Form 351 §§5.2(a) and 6]

The rates on ordinary AMT income (taxable income less profits) for all taxpayers, except for married individuals filing separately, are (for 2021):

  • 26% on amounts up to $199,900; and
  • 28% on amounts over $199,900. [IRC §55(b)(1)(A)]

When reporting AMT, depreciation taken on a property is reported as unrecaptured gain taxed at rate up to 25%, the same as SIT treatment of unrecaptured gain. Likewise, the long-term capital gain rates and thresholds apply to both SIT and AMT reporting. [IRC §55(b)(3)]

The net investment income tax (NIIT)

A NIIT tax of 3.8% is also imposed on the lesser of an owner’s:

  • net investment income; or
  • AGI amounts greater than the $250,000 NIIT threshold amount for joint filers ($200,000 for single filers). [IRC §1411(a)(1)]

Net investment income (NII) for real estate investors is income, profits, and losses from:

  • operations and sales of rental property; and
  • interest income on savings and trust deed notes, earnings on land held for profit and rents received on management-free net-leased property.

The 3.8% surtax when imposed on AGI applies only to amounts of AGI exceeding the NIIT threshold of $250,000 for joint filers ($200,000 for single filers).

An owner’s AGI derived solely from salary or wages is not subject to the 3.8% tax – zero NII exist. For example, when the owner has an AGI greater than the NIIT threshold amount, but $0 in net investment income, the lesser of the two amounts ($0) results in a $0 net investment income tax.