This article sets forth the different tax rates for various amounts of ordinary income and different types of profit, the definition of terms and the accounting procedures for reporting profits.

The batching and taxing gains

On sales transactions involving one-to-four unit residential property, an Agency Law Addendum is required to be attached to the listing and purchase agreements. The addendum advises the buyer or seller to seek tax advice from a more “competent professional” than the agent they have employed under the listing agreement. [Calif. Civil Code §2079.16; see first tuesday Form 305]

However, all real estate licensees are considered professionals. Further, they are permitted to give tax advice, voluntarily if they so choose, or to the best of their knowledge in response to the client’s inquiry, in any real estate transaction they are negotiating. The tax advice becomes part of the real estate services rendered for which they are paid. Thus, a broker and his agents may act as the “competent professional” sought out by the client to give advice.

For a broker and his agents, knowledge about income tax law is a valuable asset to be put to work when assisting clients in real estate transactions. Tax knowledge, dispensed as advice in an opinion given to a client by a broker or sales agent, becomes “goodwill.” In turn, the earning power of the goodwill generates further employment in the form of more listings, repeat clientele and the entrusted handling of larger dollar transactions.

Counseling a client on the tax aspects of a sale or exchange early in the broker-client relationship typically induces an ongoing tax discussion. Of course, the objective of the discussion is to achieve the most favorable tax results available to the client without altering the underlying financial benefits and risks of a sale.

The earlier in the client relationship the tax discussion is held, the more likely the client is to consult with and ask questions of other “competent professionals” about his tax-related discussion with his broker. An early consultation with others allows the client to examine the alternatives suggested by his broker, such as an installment sale or the purchase of replacement property in a §1031 reinvestment plan.

In situations involving other professional advisors, the broker has a duty of care owed to his client to present information he believes may impact or be contrary to the advice given to the clients by others, such as the client’s attorney. [Brown v. Critchfield (1980) 100 CA3d 858]

Through the collective efforts of all advisors, the transaction will be structured to meet the client’s needs, including the best tax results under the circumstances.

The changing market conditions and the innuendos and nuances of real estate negotiations are usually better known to those brokers and agents who are regularly involved in real estate transactions. Also, alliances built by a broker with other professionals who are brought into a transaction by a client may survive long after the transaction is closed.

Also, a broker’s failure to recognize and coordinate activity in a transaction with other advisors of the client can produce disastrous results for the broker. A broker who persuades a client to rely on his advice over correct advice of other professionals will be liable for any losses suffered by the client due to his (mis)advice. [In re Jogert, Inc. (1991) 950 F2d 1498]

A worksheet for preparing estimates

The sale of every parcel of real estate, except dealer property, produces a profit for the seller if the price exceeds the seller’s cost basis in the property. This fact, coupled with an understanding that the taking of a profit on the sale produces a tax liability owed to federal and state tax collecting agencies, is commonly known to all brokers and sales agents who represent sellers.

Before beginning a discussion about the tax aspects of a sale, a worksheet should be prepared. On it, the listing agent breaks down the profit taken on a sale into the different types of gains, called batching, so the seller’s tax liability on closing a sale can be estimated. A secondary objective sought by a listing agent during a review of the profit tax liabilities estimated on the worksheet is a follow-up discussion on how to exclude, exempt or defer the tax.

Thus, the seller who initially sought only to “cash out” his ownership of real estate might be converted to a §1031 reinvestment plan and acquire a replacement property. As an alternative, the seller might structure a sale as an installment sale to retain the earning power of his untaxed equity until the deferred tax on the profit is actually paid.

The worksheet conveniently suited for this introductory discussion about profit taxes is titled the Individual Tax Analysis Form (INTAX). [See Form 351 accompanying this article]

The top half of the form is a review of the items of income, profit and loss which can be gathered to set the seller’s taxable income or loss. However, the estimated taxable income for the year of the sale for a high-income earner is not needed to batch the gains and estimate the profit tax on a sale.

Also, the seller who is a high-income earner is more likely to respond favorably to the agent’s tax analysis than a low-income earner. The agent’s INTAX analysis (of the profit only) should be made at the time the listing is taken, and then again when a purchase agreement offer is reviewed. The discussion with the seller on each occasion should be limited to the amount of his profit on the sale, the batching of his different gains (in the profit) and the tax liability due on these gains.

The amount of the tax liability for profit taken on a sale is usually not known to the seller. The disclosure of the estimated amount typically is a mental relief for the seller – the tax he can anticipate paying as estimated by the broker is now known.

The INTAX worksheet contains separate columns for calculating the standard income tax (SIT) and alternative minimum income tax (AMT). The distinction between the two is critical as it may well affect the client’s tax liability for his business, professional and investment income. However, the distinction does not have an influence on the profit taxes due on the sale of a capital asset. The taxation of gains (profit) on a sale is the same no matter the other income and deductions of a high-income earner.

Thus, a listing broker’s tax discussion of a capital asset is limited to the types of gains contained in the profit on the sale, and the tax due on these gains. [See Form 351 §§5.3 and 5.4]

Editor’s note — It is unnecessary to use the INTAX to assist a buyer of real estate in the selection of property based on tax consequences. The Annual Property Operating Data sheet (APOD) provides the depreciation schedule for the only tax benefit available to a buyer during his ownership and operation of the property. Further, the increase or decrease in the buyer’s annual taxes brought about by his acquisition of a property is calculated on the Comparative Analysis Projection Worksheet (CAP). [See first tuesday Form 350 and Form 353 at §5.3]

When a seller enters into a §1031 reinvestment plan and acquires a replacement property of equal-or-greater debt and equal-or-greater equity than the property he sold, he has no profit which will be taxed. (Other formulas produce the same no-tax result.) The avoidance of tax on the profit is demonstrated by the preparation of a Profit and Basis Recap Sheet. [See first tuesday Form 354]

However, the seller’s §1031 reinvestment plan might entitle him only to a partial §1031 exemption due to the withdrawal of cash, receipt of a carryback note or a reduction in mortgage debt. Here, the INTAX form section for batching the profit which will be taxed is most informative since it will help establish the amount of cash the seller will pay profit taxes once his partial §1031 transaction is completed. [IRC §1031(b)]

25% and 15% profit tax ceilings

Typically, the sale of investment real estate, or business-use real estate held for more than one year, is at a price greater than the depreciated cost basis remaining in the property. Thus, the owner takes a profit on the sale.

The gross profit taken on a sale is the difference between the sales price and the seller’s remaining cost basis in the property he sold (formula: price minus basis equals profit). Deduct the transactional costs of the sale from the gross profit and the result you get is the net profit.

Net profit, like ordinary income, is taxed, unless exempt or excluded, or reduced by other losses, called an offset. [Internal Revenue Code §1001]

However, net profit is not taxed as ordinary income, but as a gain. Several types of gain exist within the net profit on a sale, each gain having a different tax rate.

Before taxing the amount of profit taken on a sale of property, the amount is reduced by all short-term and long-term capital losses (current and carried forward) the seller has incurred due to other sales within the income category for the property sold. Thus, the net profit is established within each of the three income categories (business, passive and portfolio).

The net profits from each income category are then combined to set the owner’s net profits for the year, called net capital gains by the Internal Revenue Service (IRS). It is the net capital gains which are batched by type of gain and taxed, unless offset by losses incurred by the owner in his rental operations or business. [See IRS Form 1041 Schedule D, Part IV]

The tax rates applied to net profit taken on the sale of real estate depend on the type of gain the profit represents.

Net profits from real estate sales include gains, such as:

  • recaptured gain, represented by the amount of excess accelerated depreciation (occasionally taken on acquisitions prior to mid-1986) over straight-line depreciation for the period, and taxed at ordinary income rates ranging from 10% to 35%, a type of gain which will not exist on a sale after 2005;
  • unrecaptured gain, represented by the total 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), and taxed at the maximum rate of 25% [IRC §1(h)(7); first tuesday Form 351 §5.3]; and
  • long-term gain, also called adjusted net capital gain by the IRS, represented by the amount of profit remaining after subtracting all depreciation deductions from the net profit, and taxed at the maximum rate of 15% [See first tuesday Form 351 §5.4]

Recaptured gain has no relevance today. For properties acquired in 1985 or early 1986 and then depreciated on an 18- or 19-year accelerated cost recovery schedule (ACRS), only a very small portion of the profit on a sale in 2005 will be taxed at ordinary income rates, and none in 2006 and beyond. All other properties, no matter when acquired, will, as a result of today’s cost recovery schedules, have no excess depreciation (over the straight-line amount) to declare. Thus, no portion of their profits will be taxed at ordinary income rates.

Unrecaptured gain is the deceptive title applied to the amount of all straight-line depreciation deductions taken on a property. Thus, on the sale of property, the portion of the net profit produced by the depreciation the seller deducted during the period of his ownership will be taxed at a maximum rate of 25% as unrecaptured gain.

For example, the seller of a rental property paid $1,000,000 for the property 10 years ago. His depreciation deductions taken during his ownership total $250,000, approximately 1/3 of the value of the improvements when he bought the property. He is now selling the property for $1,600,000, a profit of $850,000 over his remaining cost basis of $750,000. Also, his taxable income from other sources pushes him into the 28% ordinary income tax bracket. [See first tuesday Form 351 §4]

The seller’s profit of $850,000 is now broken down – batched – into:

  • unrecaptured gain, consisting of the $250,000 in depreciation deductions, which is taxed at the 25% rate for a tax liability of $62,500 [See first tuesday Form 351 §5.3]; and

  • long-term gain, consisting of the remaining profit of $600,000, which is taxed at the 15% rate for a tax liability of $90,000.

The long-term gain is that portion of the net profit represented by the increase in the sales price received by the seller over the purchase price the seller paid to acquire the property (plus or minus new or destroyed improvements). If the long-term gain is not offset by losses incurred by the owner, the amount of the gain will be taxed at the maximum rate of 15%.

Sometimes the net profits from a sale are greater than the seller’s taxable income for the year of the sale due to excessive operating losses experienced by the seller on this or other properties (expenses exceeded income in rentals or the owner’s business). If profits are greater than the taxable income, the profits taxed are limited to the amount of the taxable income. Thus, excess rental or business operating losses have offset profits on the sale.

However, profits are offset from taxation in the reverse order of descending rates. Thus, the result is the lowest profit bracket of 15% (long-term gain) is the first to be offset by the owner’s operating losses.

For example, consider the same facts as in the prior example, except that the seller suffered a $200,000 loss operating his rentals and his business (which motivated him to sell the property). Thus, his taxable income amounts to $650,000, less than the $850,000 profit taken on the sale. He will pay profit tax only on the $650,000 taxable income as follows:

  • an unrecaptured gain of $250,000, taxed at the 25% rate; and

  • a long-term gain of $400,000, consisting of only a portion of the remaining $600,000 balance of the profit, and taxed at the 15% rate for a tax liability of $60,000, not $90,000, the amount which would have been paid without the operating losses. Thus, the seller receives a tax savings of $30,000 to subsidize 15% of the seller’s $200,000 operating loss.

Other types of profit do exist. Profit on the sale of coins and art is called a collectibles gain, and is taxed at a maximum rate of 28%, unless the collectibles sold are the subject of a §1031 reinvestment exemption. Profit taken on the sale of small business stock is called a §1202 gain, and is also taxed at a maximum rate of 28%. [IRC §§1(h)(4); 1(h)(5); 1(h)(7)]

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). Adjusted gross income, less any personal and rental loss deductions, becomes the owner’s taxable income. [IRC §63(a)]

To determine the tax liability of the owner, the taxable income is broken down into two major components:

  1. Net profit (net capital gain) [See first tuesday Form 351 §5.1]; and
  2. Ordinary income. [See first tuesday 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 then entered as the net profit component of the taxable income. [See first tuesday Form 351 §5.2]

The combined net profit is then subtracted from taxable income, resulting in the amount which will be taxed as ordinary income. [See first tuesday Form 351 §5.1]

Ordinary income is taxed at standard income tax (SIT) rates ranging from 10% to a ceiling of 35%, or at alternative minimum income tax (AMT) rates of 26% and 28%, whichever produces the greater amount of taxes.

Batching gains for setting taxes

To calculate the tax on net profits, 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 there is not any remaining profit to be taxed:

  1. First, recaptured gain (excess depreciation), taxed at ordinary income rates (10% to 35%);
  2. Second, any collectibles gain and business stock gain, taxed at a 28% rate;
  3. Third, any unrecaptured gain (straight-line depreciation), taxed at a 25% rate; and
  4. And then, any long-term gain not offset for operating losses from rentals or business, taxed at a 15% 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 as profit on the sale of assets. Dealer property is property held primarily for sale to customers of a business, not for investment or productive use in a business. [IRC §1231(b)]

Profits remaining on the sale of a principal residence which are not offset by the Internal Revenue Code (IRC) §121 $250,000 per person profit exclusion are 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 years ago for their principal residence that they are now offering for sale at $900,000. On the sale, they will take a profit of $650,000 since a principal residence is a capital asset. They qualify for a combined §121 exclusion from profit tax of $500,000. Thus, they must report a profit of $150,000.

The homeowners did not take any depreciation, in whole or in part, on the residence as a home office or as a rental. Thus, their cost basis remains unchanged as the price they originally paid for the residence. Since their taxable income exceeds the profit on the home and places them in the 28% ordinary income reporting bracket, the $150,000 in entire profit remaining (after deducting their combined $500,000 principal residence profit exclusion) will be reported as a long-term capital gain and taxed at the 15% rate, a tax liability of $22,500. [See first tuesday Form 351 §5.4]

However, no loss on the sale of the principal residence may be reported or used to offset investment or business category income or profits.

Also, the profit allocated to any note carried back by a seller on an IRC §453 installment sale is reported each year as the principal payment is received. The profit allocated to the principal in the installment payments is also batched (by the type of gain taken on the sale) and reported as principal is received on the note. The first profits in the down payment and installments to be taxed (until they no longer exist) are the gains with the highest rate.

For example, real estate used to provide warehouse space for an owner’s business is sold for the net sales price of $1,000,000. Terms include a $100,000 down payment, the buyer’s assumption of a $400,000 mortgage and the execution of a $500,000 carryback note for the balance of the price. Depreciation deductions of $150,000 have been taken during his ownership, 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) 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), the total profit on the sale.

As a result of batching, $150,000 of the profits are unrecaptured gain (depreciation) which will be first reported before reporting any long-term gain on the sale. Thus, profit taxes will be paid as cash is received from the down payment, and later as installments of principal are received.

Thus, the entire profit of $83,333 in the down payment will be reported as unrecaptured depreciation gain taxed at the 25% rate. The balance of the unrecaptured depreciation gain will be reported on 83.3% of the principal payments as these are received on the carryback note, until the unrecaptured gain has been fully reported. All remaining profit received in subsequent installments on the carryback note will be long-term gain taxed at 15% when received. [See first tuesday Form 351 §§5.3 and 5.4]

Alternative minimum tax

The tax on ordinary income must be calculated twice, once under the standard income tax (SIT) rates and again under the alternative minimum tax (AMT) rates. Not so for profits. Whichever SIT or AMT calculation sets the highest amount, that amount will be the tax paid on the ordinary income portion of the taxable income. [IRC §55(a); see first tuesday Form 351 §§5.2(a) and 6]

The AMT tax rates on ordinary AMT income (taxable income less profits) are:

  • 26% on amounts up to $175,000; and
  • 28% on amounts over $175,000. [IRC §55(b)(1)(A)]

When reporting AMT, straight-line depreciation taken on a property is reported as unrecaptured gain and taxed at 25%, the same handling and rate as the ceiling rate for standard income tax treatment of unrecaptured gain. [IRC §55(b)(3)(B)]

Likewise, the 15% long-term gain rate ceiling applies to AMT reporting of long-term profits. [IRC §55(b)(3)(c)]