Chandler Properties Blog

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.

About the Author
The Millionaire Real Estate Investor is authored by Gary Keller of Keller Williams Realty International.  Gary has over 25 years of real estate investing and industry experience.  In this book, he uses that experience to explain how to layout a framework to becoming a successful real estate investor.  

Why I Like this Book
I like this book because it is not a “get rich quick” program that promises to make you rich with no money down tactics.  On the contrary, it explains a method that is a lifelong approach to investing in real estate.  His method focuses on always being “out looking” at properties and buying every 1 or 2 years when a great deal comes along.  He hits home the message of:  learn your market, look for properties that are selling at a 20% discount to fair market value, putting 20% down on the mortgage, and becoming a master of your niche.  This is a very similar mindset to Warren Buffett.  Buffett teaches us that we don’t have to understand every kind of investment, but we need to define a circle of competency and stick with it.  Gary Keller does a good job of carrying this thinking into real estate investing.

Living Below Your Means
During the book, he talks about budgeting personal expenses, living within you means, and tracking your net worth.  The idea of living below your means and saving for down payments on properties is something I have never heard from a Robert Kiyosaki book or a “Get Rich” program, but is so important to building wealth.

Profiles of Successful Real Estate Investors
At the end of the book, Gary profiles 21 real estate investor success stories.  These stories are encouraging for real estate newbies and all include the same common theme of doing something you love and working very hard at it.  I found these stories entertaining and inspirational.

Conclusion
Overall, I think this is a really good book for a new to intermediate investor.  It provides very practical advice on how to get started in the business as well as some inspiration.  So if you are looking for a good read, I definitely recommend “The Millionaire Real Estate Investor” by Gary Keller.  Amazon.com is currently selling it for less than $15.  Click on the link to the right and it will take you directly to it on Amazon.com.