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Tax Liabilities When Selling Investment Properties
If you’re new to real estate investing, it’s likely you’re reading every book and article on the topic — or you should be! — in order to prepare yourself for all obstacles. One aspect of real estate investing that many individuals often overlook is tax liabilities when selling their investment properties.
In an effort to give you the best advice and information, I consulted three different experts (including an experienced accountant) to make sure you’re informed.
As a general rule, Margo McDonnell, president at 1031 CORP, recommends you always consult your tax advisor prior to selling your investment property, to determine the tax consequences of your sale. “Knowing the state and federal tax liability will allow you to make more informed decisions,” McDonnell said. “Be sure to take into account capital gains, depreciation recapture, state income tax and the 3.8% Unearned Investment Income Tax.”
“Don’t forget about taxes! Sounds simple enough, but many real estate investors will not think about potential tax implications when selling, and will find that they may have a tax gain on the property which will significantly reduce their after-tax proceeds,” Edward McWilliams, CPA of nine years and Partner at Cerini & Associates, LLP, told The Post. “This can impact the investors’ ability to deploy these gains in other investments or for personal use.”
Ahead find five key points related to real estate tax practices:
1. Think about doing a 1031 exchange…
“Considering your end goal — and subsequent strategy — is crucial in all decisions investment-related, especially as you prepare to sell one or more of your assets,” Bob Pinnegar, President & CEO of the National Apartment Association, said. “When preparing to sell, first consider the type of sale. For instance, are you seeking to cash out or are you looking to exchange your asset for a larger property? This decision drives the sale process, particularly when it comes to applicable taxes.”
“If your end goal is to exchange the property for another, 1031 like-kind exchanges might make the transition easier, help you manage risk and ultimately defer capital gains taxes,” said Pinnegar.
While a 1031 exchange is a powerful tax strategy, it is not always the right one for every situation so make sure you consult your tax advisor to determine if a 1031 exchange is right for you.
“Currently, the Internal Revenue Code allows for taxpayers to do a 1031 or like-kind exchange with real estate. A 1031 exchange allows the taxpayer to defer any tax implications on the sale of the property so long as they invest the proceeds in a new property (“like-kind”),” McWilliams said.
“In order to qualify, taxpayers will need to follow specific steps, guidelines and timelines, including the use of a Qualified Intermediary and generally completing the transaction within 180 days,” McWilliams added.
“Investors should note this treatment is not automatic and if these steps are not followed correctly the entire gain will be taxable, even if they invest in a new property with the proceeds. A 1031 exchange also will incur additional fees for legal, accounting and intermediary services and can add complexity to deals, so it may not be worth it for smaller gains.”
2. Be prepared to calculate the taxes on your gain…
On the other hand, Pinnegar said to keep in mind applicable capital gains taxes if you’re seeking to cash out right away. “As you prepare to pay them, take time to look back on investments you’ve made on the asset as well as depreciation,” he said. “Consider consulting a CPA to best understand how capital gains taxes will impact you.”
“Be prepared for depreciation recapture. Rental properties are generally eligible for an annual expense allowance for depreciation depending on the use of the property and its cost. When these properties are sold, any depreciation allowed will be ‘recapture,’” said McWilliams.
“The gain on the sale is generally calculated as the selling price less your purchase price and any improvements, but depreciation will reduce your carrying value (basis) in the purchase price. The gain picked up here will normally be known as ‘Unrecaptured Section 1250 Gain’ and will be taxed at a special 25% federal tax rate.”
3. Passive losses will be released…
“For most taxpayers, losses incurred in a rental activity are considered passive and therefore unable to offset other types of income, such as wages or business income. As such, real estate investors may have ‘suspended losses’ – prior rental losses they were unable to offset against other income,” McWilliams explained.
“When the property is finally sold in a 100% taxable sale, these losses are now released and are treated as nonpassive losses in the year of the sale. This may offset gains on the sale or present an opportunity for taxpayers to engage in other forms of tax planning, such as a Roth IRA conversion, in a more efficient manner.”
4. Remember you also have to pay your state and local taxes…
McWilliams also flagged that many taxpayers only think about federal income tax rates and treatment —capital gain versus ordinary or recapture rates — but “it’s important to consider that both the state the property is located in and the owner’s state of residence may impose tax on the sale as well.”
“Some states also may impose withholding at the source based on the gross amount of the sale; for instance, Vermont requires nonresident withholding based on the gross sales price of the property,” McWilliams said.
5. Individually owned properties can be subject to estate taxes…
“Estate taxes are an important element of your long-term strategy to consider. Overall, your business structure will dictate if and how estate taxes impact your portfolio,” said Pinnegar.
“For instance, individually owned properties are often subject to estate taxes. Assets owned in an LLC pay taxes differently as they are pass-through entities and are not subject to corporate taxes like a corporation. Properties held within a trust can be transferred to others without estate taxes, and this route may be beneficial for those particularly concerned about estate planning or considering a group investment.”
Note: each of these structures and points listed in this article is unique and complex, and you should consider consulting with a tax advisor or CPA that can best identify the implications of applicable taxes on your portfolio.
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