The following excerpt is from the current edition of Tax Benefits of Ownership, which gives an overview of the components that comprise the sales price of real estate and what determines the sales price for income-producing property.

Different views, different analysis, different result

A seller’s agent, as good practice, discloses the amount of net proceeds the seller can expect on a closing at the sales price under consideration. To accomplish this pricing disclosure as a critique for sales, the seller’s agent initially prepares a seller’s net sheet for review with the seller when presenting the listing agreement. The agent’s calculations are based on the listing price the agent and seller agree upon for marketing the property.

Later, the agent repeats the net sheet analysis for each listing price modification approved by the seller, including submission of a buyer’s purchase agreement offer.

To aid in preparing an estimate of the dollar amount of net proceeds a seller can expect to receive on a particular sales price, the agent fills out a form called a seller’s net sheet. [See RPI Form 310]

Is the seller’s awareness of the amount and nature of net proceeds they will receive on closing the only financial consequence the seller will experience on a sale? Is the amount of net profit on the sale the same as the seller’s net proceeds?

Net proceeds and profits are unrelated concepts

The answer to both questions is no. The seller’s profit or loss reported on a sale is always different in amount and unrelated to net proceeds received on the sales price paid by a buyer. However, the sales price is the common figure to begin calculating both net proceeds of a sale and the profit or loss on a sale. While the seller takes the net proceeds of a sale to the bank, the sales price may contain profit which creates a tax liability for the seller which diminishes the net proceeds — unless the profit is tax exempt, excluded from taxes or tax deferred.

Uninformed sellers frequently believe their profit is somehow related to the amount of net proceeds they receive on a sale; that their net equity in the property equals their profit. It does not. Typically, the net proceeds are greater than the amount of profit. However, the positive spread between the amount of net proceeds and profit is reduced or reversed by cash-back refinancing, as the debt on the property increased during ownership. While the equity in the property shrinks due to increased mortgage debt the profits remain the same.

The distinction: the seller’s equity in a property and their profit on a sale are each derived by applying different data to the sales price — the mortgage debt and the seller’s cost basis, respectively. On a sale, debt and basis are never the same.

Before breaking down the sales price into its component parts for tax reporting, several economic fundamentals of real estate ownership must first be understood:

  • capital investment — made to acquire ownership and improve a property, evidenced by cash contributions, funds from loans, and cost basis carried forward from a sale in a §1031 reinvestment plan which comprise the owner’s cost basis in the property from which depreciation deductions are made. In contrast, an owner’s capital interest in a property is its current market value.
  • annual operating data — ongoing property operations that generate income (rents) and expenses which are reported annually.
  • tax consequences — brought about by acquisition, on-going ownership, and disposition of the property.

A property’s sales price, also considered its market value and the owner’s capital interest, is the only term common to all economic analysis regarding ownership of a home, business-use property or investment property (rental real estate and land held for profit on resale).

Agents advise and counsel clients on material facts enveloping a transaction they are negotiating. Material facts are aspects of a real estate transaction that if known might alter the economic behavior and decisions of the client.

Consider a first-time buyer of any type of property. Due to lack of knowledge and familiarity, they tend not to be inquisitive about:

  • acquisition costs, though known and familiar to the broker;
  • operating expenses, known to sellers and obtainable on request; and
  • income taxes, known to brokers and sales agents.

The conduct of a first-time buyer is in direct contrast to the conduct of repeat buyers of a home, business-use property, or investment property. [See RPI Form 306 and RPI Form 311]

In any real estate transaction, a thoughtful agent gives their client advice on the tax consequences of the sale. This advice is, of course, limited to what is known by the agent, issues that might cause the client to consider further or different arrangements in a transaction.

Taking a profit that is not exempt or excluded from taxation creates a present or deferred tax liability on a sale. These are material facts. The payment of any profit taxes triggered by a sale diminishes the after-tax amount remaining from the net proceeds received on the sale.

A seller interested in disposing of a property quickly breaks out their sales price into debt and equity, flipsides of the capital interest coin. It is the equity in the property the seller is cashing out, no matter how the buyer might be funding payment of the sales price.

To calculate the seller’s gross equity in the property, the amount of debt encumbering the property is deducted from the sales price. Again, mortgage debt is not used to determine the seller’s profit on a sale (except for short sales in negative-equity situations).

Capital components of the sales price

In another distinction, a seller’s present capital interest in a property is synonymous with the determination of the property’s current market value. Brokers advising an income property owner logically determine the amount of the owner’s capital interest in the property by, well, capitalizing the property’s NOI at current rates of return experienced by like-type property — an appraisal approach. The resulting capitalized value of the property becomes the price the seller seeks from a buyer, representing the total sum of the seller’s capital interest in the property.

An owner’s capital interest is defined as either:

  • the sum of the dollar amount of the property’s current mortgage debt and perceived equity; or
  • the property’s current fair market value set at the current annual rate of return on like-type properties — say, 6.5% — when inflation is low and investment opportunities are not readily available – called a seller’s market.

The seller’s capital interest in a property today is neither equivalent nor related to the seller’s previous capital investment in the property made years earlier. A seller’s capital investment is the amount they paid for the property, comprised of cash and mortgage proceeds used to purchase, improve or cover negative cash flow to carry the property, as well as any cost basis carried forward in a §1031 reinvestment plan. Capital invested sets the cost basis in a property and is also called book value.

Tax components in the sales price

Taxwise, the seller, in discussions with their agent, breaks down the sales price into basis and profit, flip sides of the tax coin. With the profit figure, the agent can determine the income tax liability created by the sale they are negotiating. The short formula for setting profit: price minus basis equals profit.

As an economic function, a tax analysis of a property’s price contributes nothing to the process for setting the price. It is a lagging event, precipitated as a consequence of the sale. Neither a seller’s remaining basis nor the profit sought plays any role in setting the market price a buyer may be willing to pay for a property. However, profit does, all too often, play a peculiar role of seller reminiscence. This environment creates a money illusion, which frequently distorts the seller’s opinion of current market value.

Buyers deciding on a price to pay are not concerned with the seller’s basis and profit. These are elements of state and federal tax reporting affecting only the seller as a taxpayer when property is disposed of. A buyer never acquires the seller’s basis, and a seller’s basis (or profit) never aids a seller or buyer when establishing a property’s value.

Again, a seller’s remaining cost basis in a property is never equal to the remaining mortgage debt. But deducting basis from the net sales price does set the seller’s profit.

On acquiring property, its cost basis is established as the total of all the expenditures related to the purchase of the property and the improvements necessary to use it or attract tenants, called placing the property in service. During the period of ownership prior to resale, a property’s cost basis is adjusted periodically due to depreciation, hazard losses and further improvements.

Taxwise, the cost basis remaining at the time of resale is deducted from the net sales price to determine whether a profit or loss has been realized by the seller. Whether the profit realized is taxed, called recognized, is a separate issue.

Editor’s note — When the purchase price paid for a property includes the equity or net sales proceeds from disposal of §1031 like-kind real estate, the basis in the property purchased is set by the remaining cost basis in the property sold (not its sales price) which is carried forward and adjusted for additional contributions or the withdrawal of money (net cash boot) and differences in the amount of existing debt (mortgage boot) on the properties.

Value altering activities

Additional improvements made by an owner of rental property, sometimes called sweat equity, contribute to a property’s value when they bring about an increase in rents. Thus, expenditures for the cost of improvements are added to the basis in the property. Conversely, expenditures by the owner for upkeep, maintenance, repair, and operations of the property are operating expenses deducted from rental income. While operating expenses add nothing to the cost basis in the property, they do maintain — and often increase — the amount the owner can demand for rent. However, the value of the owner’s capital interest in the property is often increased by value-creating maintenance they write off and, for a sale, the price increased and with it the profit (the owner’s time and effort taxed at a lower rate).

Net cash proceeds from refinancing or equity financing which are not used to purchase or improve property do not contribute to the cost basis (or affect the property’s value).

The depreciation allowance reducing the cost basis represents an annual return to an owner (from rents) of a percentage of their capital contributions allocated to improvements on the property. Accordingly, the cost basis, being the total of all capital contributions, is reduced each year by the recovery of capital from rents through the annual depreciation allowance deducted from the NOI to report income or loss from operations.