FEDERAL INCOME TAXES

Sale of real property

Principal residence

Investment real estate

Sale of real property  

Capital gain. When real estate is sold, a taxable event occurs. If the sale proceeds exceed the original cost of the investment, subject to some adjustments, there is a capital gainthat is subject to tax. If the sales proceeds are less than the original cost with adjustments, there is a capital lossAs discussed in the section on real estate investments, gain on sale is the amount realized from the sale, net of selling costs, minus the adjusted basis of the property, which is the beginning cost plus capital improvements minus exclusions and credits.

Tax law provides an exclusion of gain on a residential sale of $250,000 for an individual taxpayer and $500,000 for married taxpayers filing jointly. The exclusion of gain from sale of a residence can be claimed every two years, provided the taxpayer meets ownership and use  requirements. Losses are not deductible, and there is no carry-over of any unused portion of the exclusion.

Foreign sellers. The sale of real property by foreign sellers is regulated by the Foreign Investment Real Property Tax Act (FIRPTA), which requires buyers of such properties to withhold up to 15% of the gross proceeds from sale against the potential gains tax liability. In addition to individual sellers and buyers, the withholding obligation applies to foreign and domestic corporations, qualified investment entities, and fiduciaries of certain trusts and estates. The transaction must be reported to the Internal Revenue Service and the withheld funds transmitted  with the proper form. Instructions and the form may be found at https://www.irs.gov/forms-pubs/about-form-8288.

Principal residence    

Tax advantages. In addition to the exclusion on gains discussed above, ownership of residential real estate offers tax advantages in the form of deductions and exclusions from taxable income. Under current tax law, some of these advantages are reduced by an increase in the standard deduction and by limits on certain deductions. Owners should consult a tax professional for advice on these matters. Potential deductions and exclusions include:

  • mortgage interest

    With limitations, mortgage loan interest paid for a principal and second home is deductible.

  • property tax

    With limitations, property taxes paid for a principal and second home are deductible.

  • home equity loan interest

    If a home equity loan is used to improve the home, interest payments on the loan are deductible.

  • points and fees

    If a mortgage loan is used to purchase or build a principal residence, origination fees and points are deductible. Points are amortized on a refinance loan and deducted over the loan term on a loan to finance a second home.
     
  • gain on sale exclusions

    As discussed above.

  • IRA withdrawals

    First-time homebuyers may make withdrawals without penalty from tax-deferred IRA accounts for use as a down payment.

Investment real estate                           

Taxable income. The taxation of income from investment real estate involves the application of the investor’s tax rate to the income generated by the property after deductions and other adjustments are subtracted.

Depreciation.  Cost recovery expense, or depreciation, was discussed in the section on appraisal.  To review, depreciation is the estimated  loss of value in an improvement over time. This loss pertains only to the improved portion of real property, not to land.

In the straight-line method of estimating depreciation, it is assumed that loss occurs equally and incrementally across a period of time called the economic life of the improvement. The economic life is currently established by the IRS as 27.5 years for residential income property and 39 years for non-residential income property. The annual cost recovery expense is the total cost of the improvement  (depreciable basis) divided by the economic life period. For a simple example, if the total cost to acquire a residential income property was $1,000,000, and the land is valued at $200,000, the value of the improvement may be said to be $800,000. The annual cost recovery expense is then $800,000, divided by 27.5, or $29,091.

Installment sales. An installment sale, land contract, or contract for deed, as discussed in the section on real estate contracts, allows the seller to defer receipt of some or all of the purchase price of a property over a specified period of time. At the end of the period, the buyer pays the vendor the full purchase price and the vendor deeds legal title to the vendee. Since the seller is not liable for capital gains tax until the purchase price is received, the installment sale lowers the seller’s tax liability in the year of the sale.

Like-kind exchanges.  Also as discussed in the section on real estate investment, an investor can sometimes defer the reporting of gain or loss, and, hence, taxation of gain, by participating in an exchange of like-kind assets. The legislation that deals with like-kind exchanges is contained in Section 1031 of the IRS code. These tax-deferred exchanges are sometimes called Section 1031 exchanges and Starker exchanges, named for an investor who won a case against the IRS.