Many single-family landlords are retirees who bought a property 30 years ago to rent out and help supplement their retirement. Recently, a lot of these landlords have decided they no longer want to be landlords. When they sell, their biggest consideration is the capital gains tax, but there are other parts of the tax bill that small landlords don’t think about, and they can be bigger.
I buy small rental properties and houses, and since small landlords sell to us often, I’ve talked with many of them about these tax surprises. Here are the questions I think small landlords should consider when they decide they no longer want to be landlords.
Executive Summary
- There is depreciation recapture, even if the landlord didn’t take depreciation.
- Documented improvements can lower the gain, if the landlord has the records.
- State tax, the Net Investment Income Tax and state withholding at closing can reduce the cash received at closing.
- An installment sale spreads out the gain, but the 25% portion generally comes first.
- Selling a vacant property is different from selling a property with a tenant.
1. Depreciation recapture, even if they never took depreciation
Most clients are surprised that part of their gain is attributed to depreciation and taxed at a higher rate. When a rental property is sold, the gain attributable to depreciation on the building is generally taxed as unrecaptured Section 1250 gain, at a rate of up to 25%.
What often shocks clients is that this applies to depreciation that was allowed or allowable. Landlords who never took depreciation still must reduce their basis by the depreciation that could have been taken. Clients often miss depreciation on their returns, and in many cases this can be corrected by filing Form 3115, so the missed depreciation isn’t lost. This is usually much easier while the client still owns the property.
2. Basis and the records nobody kept
Your client’s gain is not simply the sale price minus the purchase price. The gain is the amount realized less the adjusted basis, and the adjusted basis includes improvements made to the property. The costs of improvements like an added bathroom, a new HVAC system or a new roof are often overlooked and can add up to many thousands of dollars.
The challenge is proof. Have your clients begin collecting records such as checks, contractor invoices, building permits and depreciation schedules. Building permits are often available online and are comparatively easy to find. Improvements that were already depreciated need to be accounted for correctly, and the records for those improvements should also be located.
3. Layers above the federal rate
Long-term capital gains are taxed at 0%, 15% or 20%, depending on the client’s taxable income. One large gain can push a client into the highest capital gains bracket for that year. The gain may also be subject to the 3.8% Net Investment Income Tax if the client’s modified adjusted gross income is above $200,000 for a single taxpayer or $250,000 for a joint return.
State income taxes also apply. In California, long-term capital gains are taxed as ordinary income at rates up to 13.3%. California also generally requires withholding at closing, typically 3 1/3% of the sales price. The withholding may be reduced or avoided if the seller elects an alternative calculation or an exemption applies.
4. Suspended passive activity losses
Long-time landlords may have suspended passive activity losses from prior years in which the rental generated a loss. A fully taxable sale of the landlord’s entire interest to an unrelated party generally allows the landlord to use those suspended losses. Verify the carryforward amounts on prior returns, as they may reduce the landlord’s tax liability.
5. Options when the bill looks large
Several options are available if the estimate is unacceptable.
Under an installment sale, the client recognizes the gain as payments are received. Clients should understand that the gain taxed at the 25% rate is generally recognized first, so the early payments carry the highest rate. The client also takes on the buyer’s credit risk for the payments.
A 1031 exchange defers recognition of the gain if the client wants to keep investing in real property. There are strict requirements, including identifying a replacement property within 45 days of the sale and acquiring it within 180 days, with a qualified intermediary holding the proceeds. A client who is selling to leave the landlord business may not find a 1031 exchange useful.
Timing is also important. Some clients may want to sell in a year when their other taxable income is lower. Closing in January instead of December can also move the gain into the next tax year.
6. Occupied or vacant: it affects the numbers
Who is occupying the property affects the numbers. Buyers who plan to live in the property will usually want it vacant. Vacating the property may take time and cost the seller rental income, and in some cases the landlord may be required to pay the tenant relocation assistance. An investor may be willing to buy the property occupied, often at a lower price, but with a faster and more certain closing.
That choice affects the amount realized, the selling expenses and the tax year in which the sale occurs. Run the numbers with the client to help them understand the after-tax impact of each option.
The discussion to have now
This discussion needs to take place before the property is listed for sale. An hour spent reviewing the client’s records of improvements, depreciation history and carryforwards, along with an estimate of federal and state taxes, can help avoid the landlord’s biggest surprise: realizing after the sale that the proceeds, after taxes, are much less than expected.
ABOUT THE AUTHOR:
Victoria Sharma is the manager of Cash Home Buyers CA, a Los Angeles-area company that purchases homes and small rental properties directly from owners.
Sign in to get access to this free resource, and all of our whitepapers and reports.
Download this content today!
Register Now Already registered? Click here to Log In
Tags: home sales, Income Taxes, real estate, realtor, rental properties, renters, Taxes
