Calculating Real Estate Gain

In the various discussions I have with potential 1031 exchange clients, I sense confusion in the calculation of taxable gain. Some do not consider depreciation recapture, others assume a loan payoff reduces gain or the net cash received represents their "profits". Many assume where there is no cash resulting from settlement, there is also no taxable gain.

In simple terms, the taxable gain in the sale of real estate represents the difference between the net sales price after selling expenses minus the depreciated basis of the property. Loan payoffs do not reduce gain, but they do reduce the net cash to seller. The net cash received at settlement may coincidentally be near or equal to the "profits", but are not related and are separate and distinct items.

Selling expenses include such items as real estate commissions, local transfer taxes, attorney and settlement company fees, repairs, etc. Selling expenses do not include rent or security deposit credits, property tax adjustments or property insurance adjustments.

The depreciated basis of a property is derived from the acquisition cost of the property, including acquisition expenses, plus capital improvements, minus depreciation expense. If the property was acquired in a 1031 exchange, the original acquisition cost would have been reduced by the deferred gain rolled from the previous property sold in the exchange. Acquisition expenses would include such items as title insurance, attorney and settlement company fees. A capital improvement is generally an enhancement that extends the useful life of the property or increases its value. A nonresidential property is depreciated over 39 years and a residential property is depreciated over 27.5 years. Depreciation is applied to the building and improvements, but not the underlying land.

When a property is sold for more than the depreciated basis, it has a taxable gain. The taxable gain can consist of both appreciation and depreciation recapture.

The net sales price after selling expenses minus the original acquisition cost plus improvements represents the appreciation portion of the sale. Appreciation is taxed at capital gains rates ranging from zero to 20%, plus Affordable Care Act tax of 3.8%, for properties held for one year or more, or from 10% to 37% for properties held for less than one year.

Where there is no appreciation, a property sold for less than the original acquisition cost plus improvements may still have a taxable gain due to depreciation recapture or a previous 1031 exchange.

The original acquisition cost plus improvements minus the depreciated basis represents the amount subject to depreciation recapture. Depreciation recapture is taxed at a flat rate of 25%.

The entire taxable gain, both appreciation and depreciation recapture, are generally also subject to state income or capital gains taxes. Some states add the entire gain to the taxpayer's other ordinary income, resulting in the taxpayer being in a higher state income tax bracket, while other states may have a capital gains tax rate or flat tax that they apply. Some states will tax a taxpayer based on residency, while others may tax on the property location.

Both appreciation and depreciation recapture taxes can be deferred using a 1031 exchange providing the taxpayer purchases a property of equal or greater value and reinvests all of the net cash from their sale. All states, except Pennsylvania, follow the federal 1031 exchange regulation and allow for a deferment of state taxes as well, even if the reinvestment is in another state.

If a taxpayer utilizing a 1031 exchange, does not purchase a replacement property of equal or greater value, or does not reinvest all of the net cash from their sale, the cash not reinvested, or the shortfall in net sales prices is called "boot" and is taxable at both the federal and state levels. "Boot", if any, is first taxed at the depreciation recapture rate of 25% until fully recaptured. If the "boot" exceeds the depreciation recapture amount, then capital gains rates are applied to the excess. The remaining taxable gain and the depreciated basis of the old property are transferred to the new property and deferred until a later sale, or exchange, or potentially eliminated upon death of the taxpayer.

Although complex, we hope the above eliminates some of the misconceptions and confusion about calculating the gain on the sale of real estate.