Published 2 February 2018
Editors note: This is the first in Gary Sandler’s two-part series on dealing with the tax ramifications of selling rental properties. Look for the second installment in the Feb. 11 edition of the Sun-News.
LAS CRUCES – Owning a rental property has its advantages. A steady stream of income, the ability to write off expenses and depreciation, tax savings and the prospect of annual price appreciation are just a few. There are also a number of disadvantages, the most significant of which are the tax consequences that arise when the property is sold.
The key to mitigating those disadvantages is to plan ahead. Many rental property owners, especially the mom-and-pop variety, do a good job of figuring out if the property will generate enough income to offset the mortgage payment, lack of income during periods of vacancy, and operating expenses. Few, however, adequately plan their exit strategy to lessen, postpone or avoid altogether paying taxes on the appreciation and depreciation that accrued during the term of their ownership.
Since this topic can be exceedingly complicated and specific to each individual investor, it is important to seek advice from a tax professional or qualified Realtor – preferably before a rental property is purchased and certainly before it is sold. Many of the rental property owners who failed to seek expert advice have been unpleasantly surprised at tax time. Given the space limitations here and the myriad of possible tax consequences landlords can encounter, the following example will hopefully inspire future and current landlords to put together a business plan that is specific to their situation.
Take the purchase of a small three-unit, $150,000 apartment complex, for example. Lenders typically require 20 percent down, which means that you can leverage the purchase using only $30,000 of your own money and a mortgage of $120,000. Let’s also assume that the property increases in value 4 percent annually for 10 years, resulting in a value of just over $222,000 a decade from now. During the rental period, the three tenants each pay $500 per month, for a total rental income of $18,000 annually.
While $18,000 is a respectable amount of gross income, the net income after expenses for repairs, property taxes, insurance and vacancies is typically somewhere around 70 percent of the gross, which in this example is roughly $12,600 annually or $1,050 per month. Subtract from that number the monthly mortgage payment of around $808, including principal, interest at 4.5 percent, taxes and insurance, and you pocket approximately $242 per month or $2,904 annually. Then there’s the depreciation the IRS allows you to take as the property wears out.
Residential income properties must be depreciated over 27.5 years (39 years for commercial properties), which translates to an annual depreciation rate of 3.64 percent. Depreciation can only be applied to the improvements on the property and not the land, since the land never “wears out.” A very rough rule-of-thumb is that the improvements make up around 75 percent of the overall value of the property. In our example of a $150,000 property, the annual depreciation on the $112,500 worth of improvements would be around $4,095. That amount not only offsets 100 percent of the property’s annual net income of $2,904, it creates a paper loss of $1,191. Ergo, no taxable rental income.
Now it’s time to sell. During your decade of ownership, the property has increased in value by $72,000, to $222,000. At the same time, the $150,000 basis for the property has been depreciated by $4,095 per year, or by $40,950 over the decade, to a new deprecated basis of $109,050. The IRS treats the difference of $112,950 (less acquisition and sale costs, plus any capital improvements) as a long term capital gain. Long term capital gains are typically taxed at 15 percent, resulting in a $16,943 tax bill on the sale of our $150,000 property.
Uncle Sam doesn’t stop there. In addition to the 15 percent capital gains tax, the IRS also recaptures 25 percent of the depreciation that was taken over the years. In our example, the seller will also be on the hook for 25 percent of the $40,950 in depreciation, for an additional tax bill of $10,238. The end result is that our investor will pay a total of $27,181 on the sale of the property he or she purchased for $150,000 ten years ago and sold for $222,000 today.
One more calculation. Let’s say the seller nets $108,240 after deducting from the $222,000 sales price brokerage fees and closing costs of $17,760 (around 8 percent) and the remaining loan balance of $96,000. In the end, the seller will have to pay the IRS $27,181 out of the remaining proceeds, leaving a net profit of $81,059 to save, reinvest or blow at the casino after all is said and done.
According to a recent report from the U.S. Census Bureau, 46.1 percent, or 19,533, of the 42,370 housing units located within the city limits of Las Cruces are utilized as rental properties. That means that potentially hundreds of uninformed rental property owners could be unpleasantly shocked when they file their tax returns following the year of their sale.
If only there was a way to avoid paying Uncle Sam his unfair share. Well, there is, and I’ll explain how next week.
See you at closing.
Gary Sandler is a full-time Realtor and president of Gary Sandler Inc., Realtors in Las Cruces. He may be reached at 575-642-2292 or Gary@GarySandler.com