This 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.
INTAX for the seller
Before an agent enters into a discussion with their seller about the tax aspects of a sale, the agent needs to prepare an Individual Tax Analysis (INTAX) form. On it, the agent breaks down the profit taken on a sale into the different types of gains, called batching. Without first batching the gains, the agent cannot estimate the seller’s tax liability generated on closing a sale the agent negotiated.
During a review of the profit tax liabilities estimated on the INTAX form, the seller’s agent needs to discuss methods available to the seller to exclude or exempt profit, or defer profit taxes on the transaction under consideration.
Batching gains to set taxes
To calculate the income tax on net profits from a sale, profits are broken down and batched into the types of gain which constitute the net profit. Then, profits are taxed by their type of gain in the order of descending rates, until no profit 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 long-term gain not offset by operating losses from rentals or business, taxed at a 15% and/or 20% rate. [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. Dealer property is held primarily for sale to customers of a business, not for investment or productive use in a business. [IRC §1231(b)]
The profit tax ceilings
Typically, a seller takes a profit on the sale of investment real estate or business-use real estate held for more than one year when the resale price is greater than the price the seller paid for the property and improvements. The gross profit taken on a sale is the difference between the sales price and the seller’s remaining cost basis in the property sold (price minus basis equals profit). Further, when you deduct the transactional costs of the sale from the gross profit the result is the net profit.
Net profit, like ordinary income, is taxed, but at different rates, unless exempt, excluded or deferred (or reduced by other losses, called an offset).
Before the amount of profit taken on a sale of property is taxed, it is reduced by all short- and long-term capital losses (current and carried forward) the seller has incurred on other sales within the income category of the property sold. Thus, the net profit on sales of assets is established for the year within each of the three income categories.
Next, the net profits from each income category are combined to set the owner’s net profits for the year, called net capital gains. Net capital gains are batched by type of gain and taxed, to the extent they are not offset by losses incurred by the owner in their rental category or business category operations. [See IRS Form 1041 Schedule D]
The tax rate applied to a seller’s profit on a sale depends on:
- the length of time the seller held the property before closing the sale;
- the amount of depreciation deductions accumulated during ownership; and
- the amount of the seller’s ordinary income in the year the profit is reported.
Net profits from real estate sales are broken down into types of gains, specifically:
- unrecaptured gain, represented by the accumulated amount of straight-line depreciation deductions taken on the property sold (limited to the profit on a sale when the sales price is less than the price the seller paid for the property), which is taxed up to the maximum rate of 25% [IRC §1(h)(1)(E); see Form 351 §5.3]; and
- long-term gain, also called adjusted net capital gain, represented by the amount of profit remaining after subtracting all unrecaptured gain from the net profit, and taxed at 15% or 20%, depending on the seller’s tax bracket. [IRC §1(h)(1)(C)-(D); see Form 351 §5.4]
Unrecaptured gain is the deceptive title applied to all depreciation deductions taken on a property. Thus, on the sale of property, the portion of the net profit produced by a reduction in the cost basis due to depreciation deductions taken by the seller during the period of ownership are taxed — as unrecaptured gain up to 25% — up to the net resale price.
The reverse order of descending rates
Sometimes the net profit from a sale is greater than the seller’s taxable income for the year of the sale. This is usually due to excessive operating losses experienced by the seller on this or other properties. When profits are greater than the taxable income (including profits), the profits taxed are limited to the amount of taxable income. Thus, excess rental category or business category operating losses offset profit on a sale.
However, the advantageous taxation of profits is diluted since taxable income is calculated in the reverse order of descending rates. In application, profits with the lowest tax bracket of 20% (long-term gains) are the first offset by the owner’s operating losses — which subjects remaining taxable income to higher rates.
Netting gains and taxing priorities
The total amount of all income, profits and allowable losses from each income category is called adjusted gross income (AGI). The AGI, on subtracting any personal and rental loss deductions, produces the seller’s taxable income. [IRC §§63(b), 63(d)]
To determine the tax liability of the seller, the taxable income is broken down into two major components:
- net profit (net capital gain) [See Form 351 §5.1]; and
- ordinary income. [See Form 351 §5.2]
To accomplish this breakdown of the taxable income, the net profits within each income category are added together. The combined total is entered as the net profit component of the taxable income.
The combined net profit is then subtracted from taxable income. The result is the amount which will be taxed as ordinary income.
Ordinary income is taxed at SIT rates ranging from 10% to a ceiling of 37%, or at alternative minimum tax (AMT) rates of 26% and 28%, whichever produces the greater amount of taxes.