How to Calculate Taxable Gains/Losses on Property Sale
Overview
This article is Part II on calculating taxes on rental properties. Part I covered taxable income from ongoing operations. This article will cover calculating gains/losses when a rental property is sold.
Depreciation Recapture vs. Capital Gains
When a property investor sales a rental property, the gain/loss is calculated by subtracting its adjusted basis from the sales price. The adjusted basis in the property is calculated by starting with the original purchase price, subtracting annual depreciation deductions, and adding back capital improvements. This total taxable gain has to be broken into two tranches to determine the taxes owed on the gains. Generally speaking, the gains from sale of property are treated as capital gains and taxed at 15%. However, the taxable gains related to the previous years’ depreciation are taxed at 25%. This piece is known as depreciation recapture.
Let’s examine how this works with a simple calculation. Joe Landlord purchases a property for $200,000. In year 6 he adds a new roof for $13,027. At the end of year 6, he sells the property for $300,000.
Question: What is the tax liability on this sale?
Example:
Depreciation Increase Adjusted
Deduction in Basis Basis
Original Cost $200,000
Year 1 $6,970 None $193,030
Year 2 $7,272 None $185,758
Year 3 $7,272 None $178,486
Year 4 $7,272 None $171,214
Year 5 $7,272 None $163,942
Year 6 $6,969 $13,027 $170,000
$43,027
Sales Price $300,000
Adjusted Basis $170,000
Total Gain (Sales Price - Adj Basis) $130,000
Gain Due to Depreciation ($43,027) x 25% = $10,757
Remaining Capital Gain $86,973 x 15% = $13,046
Total Tax $23,803
Results Summary
As we can see from the above example, the previous $43,027 of depreciation deductions Joe took must now be recaptured at sale date at 25% instead of the 15% capital gains rate. The remaining capital gains of $86,973 (Total Gain - Depreciation Recapture) is taxed at 15%. To answer our above question, Joe has a $23,803 taxable gain from the sale of his rental property.
This is not bad for two reasons. 1.) We have been able to defer paying taxes for several years by taking depreciation deductions. 2.) Most rental property owners fall into a 25% or higher tax bracket and therefore not being taxed at a rate higher than they would have been originally.
I hope this article presents a clear example of how the IRS Depreciation Recapture rules effect gains on sale of rental property. If you have any questions or comments, feel free to post them below.
Tags: basis, calculation, capital gain, gains, losses, property sale, rental property, Taxes