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.

Death and Taxes
Paying taxes is something we all hate doing.  However, savvy real estate investors know that real estate offers some great tax advantages.  Often a rental property will operate at a taxable loss, while simultaneously creating positive cash flow for the owner.  This is beneficial because these taxable losses reduce our tax liability while at the same time creating cash flow and building appreciation in our property.  

This blog entry is the first of a two part series on rental property taxes.  It will explain how to compute taxable income for your annual tax return. Part two will explain how to compute taxable gains/losses from the sale of rental real estate.  

Hypothetical Example
Let’s take a look at a hypothetical example that compares Taxable Income vs. Actual Cash Flow.  Assume we buy a $125,000 house that will be rented out.  We allocate $25,000 of the purchase price to land and $100,000 to the building.  This is important because land does not get depreciated.  The IRS allows us to depreciate the basis in the building over 27.5 years resulting in $3,636 of depreciation a year ($100k / 27.5 years).  Depreciation is a taxable expense, but has no effect on cash flow.  See the below example that compares Cash Basis Income to Taxable Income for a hypothetical year:

                                    Taxable                 Actual 
Revenue                     Income               Cash Flow  

Rent                            $12,000                $12,000

Expenses

Mortgage                      $6,300                   $8,400

Insurance                          600                         600

Property Tax                   1,500                     1,500

Depreciation                   3,636                            0

Total Expenses           $12,036                $10,500

Net Loss                        <$36>                 $1,500

In the above example there are two differences between “Taxable Income” and “Actual Cash Flow.”  For taxable income, only the interest portion of the mortgage is tax deductible.  For cash flow purposes, the entire $8,400 payment ($2,100 of principal & $6,300 of interest) is a cash outflow.  The $3,636 depreciation is not a cash outflow.  However, it is a taxable expense for computing taxable income.  The benefit of depreciation is that IRS rules let us assume the property will decrease in value 3.6% a year (1 / 27.5 years), when property typically appreciates a couple percent a year.  The IRS is giving us a break by allowing us to expense this depreciation now.  As we can see this property is creating $1,500 in positive cash flow, while generating a <$36> taxable loss.  If you were in the 25% tax bracket, this would save you $9 in taxes ($36 x 25%).  In sum, we are able to create $1,500 of cash while getting a $9 tax break.

Conclusion
I hope this is a clear example of some of the tax advantages of rental property.  On the next installment, I will discuss how to calculate gains/losses when a rental property is sold.  If you have any questions feel free to post a comment.