Do you believe real estate agents are legally permitted to give their clients advice on the tax aspects of a transaction?

  • No. (79%, 52 Votes)
  • Yes. (21%, 14 Votes)

Total Voters: 66

This article discusses unrecaptured gain and long-term capital gains taken on the profit of a real estate sale. It also explains ways your clients may reduce their income tax liabilities in real estate sales. 

Tax rates put to your seller’s best use 

Property owners considering the sale of a property are often averse to selling for fear of an unknown – tax consequences, a profit tax liability for the year of the sale. On the other hand, an agent representing the seller alleviates this fear by analyzing and giving advice on the estimated amount of taxes generated by their sale.

To discuss the tax aspects of a sale with anyone, real estate licensees need sufficient expertise to understand and determine the likely profit tax consequences of the transaction they are negotiating. Also, licensees need to develop their working knowledge about tax ramifications to best manage the contracting and financial aspects of a sale, whether acting on behalf of a client or as a principal. The need for this advisory approach with clients is that taxes are an inherent part of every real estate sales transaction and the reason accounting is taught as part of a real estate education for licensees.

Editor’s note: Many agents erroneously believe they cannot give their clients advice on the legal and tax aspects of a transaction, but this is not the case. Legally, real estate licensees are not only permitted to share their tax knowledge, but are encouraged to do so due to their agency relationship based on the scope of the agent’s knowledge.

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On acquiring profit tax knowledge, many agents advertise they specialize in advising investor clients on alternative structuring for generic cash-out sales transactions. Based on their advice, sellers are able to consider which steps they might take to avoid or defer profit tax, including:

  • acquiring replacement property in a §1031 reinvestment transaction;
  • carrying paper in a §453 deferred installment sale;
  • timing the closing so gain is taxed at a lesser rate; or
  • qualifying for the $250,000 per person principal residence profit exclusion.

Agents use the Individual Tax Analysis (INTAX) form to calculate the seller’s anticipated federal tax liability on a sale. California’s state income tax liability on the sale is additional, around one-third the amount of the federal tax liability. [See RPI Form 351]

The mid-income earner sells property 

Consider an agent who enters into a listing agreement with the owner of an income-producing property at a sales price of $900,000. The owner of the property acquired the property for $500,000 as shown in a title profile report.

During discussions, the owner voices concern about any profit tax liability a sale of the property might create.

since their depreciated cost basis in the property is $270,000. On a review of documents in the property profile, the owner comments on their recent refinancing of the property with a $400,000 mortgage originated to obtain cash to fund needs unrelated to the property.

Noting the mortgage balance is greater than the remaining cost basis, the agent advises the owner they might consider avoiding taxes on any profit as exempt by acquiring a replacement property in a §1031 reinvestment plan. However, the owner only wants to liquidate their properties, as they need the sales proceeds for purposes other than real estate ownership.

The agent mentions the owner’s ability to defer profit taxes in an installment sale until principal is paid on the note received in a carryback sale. Again, the owner only wants cash.

The agent offers to further assist in a profit tax analysis. Aware that taxes reduce the sales proceeds available to meet their needs for cash, the owner agrees to work with the agent on the analysis.

Initially, the agent prepares a seller’s net sheet for review with the owner based on a cash-out sale of the property at the listed price. Using the net sheet, the agent determines the amount of net sales proceeds the owner can anticipate receiving on a sale at the listed price — before payment of taxes on profits taken on the sale. [See RPI Form 310]

Starting with the listing price of $900,000, the agent deducts the $400,000 mortgage financing and estimated closing costs of $70,000. The estimated net sales price is $830,000 – $900,000 gross sales price minus $70,000 closing costs. On review of the net sheet with the seller, the agent advises the owner to anticipate receiving approximately $430,000 in net sales proceeds on the close of escrow — in the form of cash.

Further, the agent requests tax information from the owner which the owner provides, including:

  • the owner’s taxable income of $40,000, before profits on a sale of the listed property;
  • the owner’s ordinary income of $65,000;
  • accumulated depreciation deductions of $230,000 taken during ownership of the listed property;
  • the owner’s remaining cost basis of $270,000 on the listed property; and
  • the owner’s joint return, taking the standard deduction of $25,100 (for 2021).

With tax information about the owner and the property, the agent calculates the taxable profit on the sale (remember, price minus basis equals profit):

  • $830,000 net sales price; minus
  • $270,000 remaining cost basis; equals
  • $560,000 in taxable profit (gains).

However, the agent notes the profit of $560,000 is significantly larger than the net sales proceeds of $430,000. This inversion is the result of the owner’s mortgage-over-basis financial condition.

When the owner refinanced the property with a mortgage encumbrance to withdraw equity in cash (the ATM effect), they incurred no tax consequence for the cash back they received, tax-free dollars. In contrast, profit taken on a sale may or may not generate a tax liability depending on whether the profit is exempt or its reporting deferred.

On the close of a sale, the mortgage is either satisfied using funds received from the buyer or assumed by the buyer and remains of record. A portion of the mortgage principal represents profit taken on the sale and is reported and taxed (when not exempt or deferred). This tax result is in part due to debt relief in a mortgage-over-basis situation on a cash-out sale.

Next, the agent fills out the bottom portion of the INTAX form using the information provided by the owner. The owner’s estimated taxable income is $600,000. [See RPI Form 351 §4]

The taxable income consists of:

  • the owner’s joint ordinary income of $65,000; [See RPI Form 351 §1.1]
  • their total profits taken during the year of $560,000 profit – this income property sale; [See RPI Form 351 §1.4]
  • totaling their Adjusted Gross Income (AGI) of $625,000 [See RPI Form 351 §1.10] from which
  • their $25,100 (for 2021) standard personal deduction is subtracted; and [See RPI Form 351 §3.3, which is rounded]
  • totaling taxable income of $600,000. [See RPI Form 351 §4]

Note that taxable income is less than the combined ordinary income and profits on the sale which comprise the AGI. Further, that ordinary income is taxed first leaving the remainder of taxable income as gains taxed at lower rates. [See RPI Form 351 §5.1]

Taxing the profits, batch by batch, in taxable income

Calculating the approximate amount of taxes is straightforward using the Tax Batching section 5 in figure 2.  Initially, the agent subtracts from the taxable income of $600,000 all the couple’s ordinary income in the AGI, here being limited to $65,000 of professional income. This calculation sets the amount of taxable profit in their taxable income. Since the couple have ordinary income, the profits taxed will be an amount less than the profits taken during the year. [See RPI Form 351 §5.1]

Observe that the $65,000 in ordinary income exceeds the 10% ordinary income tax bracket ceiling ($19,900 in 2021 for married couples filing jointly), but not the 12% ordinary income tax bracket ceiling amount ($81,050 in 2021). Thus, two tax brackets in tandem set the amount of tax on ordinary income in taxable income.  The tax due on the ordinary income is $7,400 ($2,000 + .12 ($65,000 -$19,900)). [See RPI Form 351 §5.2(a)]

The remaining taxable income is taxed at rates on gains for the profit taken on the sale.

Before proceeding further with the tax analysis, the agent needs to batch the profit of $560,000 on the proposed sale into its component gains as they are subject to different sets of tax rates. Here, the gains which make up the profit, in the order of priority they are taxed, include:

  • unrecaptured gain on real estate ($230,000), the result of depreciation deductions taken by the owner [See RPI Form 3515.3]; and
  • long-term capital gains on the sale ($330,000), the portion of the net sales price remaining after deducting from the net sales price both the remaining cost basis and depreciation deductions. [See RPI Form 351 5.4]

Because the owner’s ordinary income ($65,000) is $15,250 less than the $80,250 ceiling for the 12% tax bracket, $15,250 of the $230,000 unrecaptured gain on the sale is taxed at the 12% rate ($1,830 in tax). The ordinary tax rate bracket is used since its tax rate is lower than the ceiling rate of 25% for unrecaptured gain.

The $214,750 balance of the unrecaptured depreciation gain ($230,000 minus $15,250) is then taxed on the next $91,700 at the 22% tax bracket ($21,700 additional tax). This leaves $123,050 in unrecaptured gain to be taxed at the 24% ordinary income bracket rate ($29,530 additional tax). Thus, the total tax on the unrecaptured depreciation gain in the taxable income is $53,060 ($1,830 + $21,700 + $29,530). [See RPI Form 351 §5.3(b)]

The owner’s taxable income now remaining to be taxed is $305,000 ($600,000 minus $65,000 minus $230,000). The remaining taxable income is taxed at the single rate set for their capital gain.

While the actual amount of capital gain on the sale was $330,000, the taxable income remaining to be taxed at the capital gains rate is $305,000, $25,000 less than the capital gains on the sale – the result of personal deductions from AGI to set the taxable income.

To set the capital gain tax rate for taxing the remaining taxable income, the agent applies the following threshold figures to the owner’s total taxable income:

For couples filing jointly in 2021, one of the following rates applies to capital gains:

  • Taxable income below $80,800 ($40,400 for individual filers) sets the tax rate at 0% for capital gains.
  • Taxable income between $80,800 and $501,600 ($40,400 and $445,850 for individual filers) sets the tax rate at 15% for capital gains.
  • Taxable income over $501,600 ($445,850 for individual filers) sets the tax rate at 20% for capital gains. [Internal Revenue Code §1(j)(A)-(B)]

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The owner’s long-term capital gain rate for taxing the $305,000 remainder of the taxable income is 20%, since their taxable income exceeds the 20% threshold for couples filing jointly ($501,600 for 2021 sales). Thus, capital gain tax on the remainder of the taxable income is $61,000 [See RPI Form 351 §5.4(c)]

Additionally, the owner’s $605,000 profits exceed the $250,000 threshold for the 3.8% net investment income tax (NIIT) by $355,000. The NIIT is a surtax on income from investment assets such as income, profits and losses from the operations and sales of rental property, interest income, stocks, bonds, and land held for profit on resale. This overage is subject to NIIT liability. When the total profit on the sale of investment properties is greater than the NIIT threshold, the excess of $355,000 in our example is subject to an additional NIIT tax of 3.8%, being $13,490 ($355,000 x 0.038).

Thus, the owner’s total tax on the sale of the property is $127,550 ($53,060 unrecaptured gain tax + $62,000 long-term capital gain tax + $13,490 NIIT). [See RPI Form 351 §§5.3(b); 5.4(c)]

Remember, the owner further owes approximately a third of these amounts in additional tax to the state of California on the sales profit and other income.

After-tax net proceeds 

 Based on the agent’s estimation of the net sales proceeds (seller’s net sheet), and profit tax liability (INTAX form) at the listed price, the total amount of after-tax net proceeds the owner anticipates from the sale is approximately $302,450 (net sales proceeds of $430,000 minus profit taxes of $127,550).

Thus, the payment of profit taxes to the IRS consumes approximately 40% of the net sales proceeds on account of the mortgage-over-basis situation. Critically, the profit tax due the IRS of $127,550 equals 23% of the $560,000 profit on the sale (state taxes being around an additional 8% of profit).

Since the owner is liquidating some of their estate to obtain cash, the agent suggests ways the owner can reduce their taxes, such as:

  • the sale of different property with a lower loan-to-value (LTV) ratio and a higher basis-to-value ratio to generate more after-tax sales proceeds; or
  • carry paper in the form of an all-inclusive trust deed (AITD) after a substantial cash down payment to minimize risk of loss and maximize tax benefits available by reporting as a carryback sale to defer and possibly reduce taxes.

Need a little more practice with the INTAX form? Follow along by downloading all of the forms mentioned in this article here, plus over 400 more real estate forms for your professional use — free.

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