Published 9 February 2020
Editor’s note: This is the second part of a two-part series. Part one was published in last Monday’s issue of the Las Cruces Sun-News.
In part one of this two-part series on the importance of planning ahead before selling a rental property, we explored the tax consequences associated with the purchase and disposition of a fictitious Las Cruces-area triplex purchased for $150,000. In this part, we’ll explore how to avoid paying taxes on the sale.
Our example established that the buyer completed the purchase utilizing a down payment of 20 percent, or $30,000, and a mortgage of $120,000. During the rental period, the three tenants each paid $500 per month in rent, for a total gross rental income of $1,500 per month, or $18,000 annually. We also surmised that the net income after expenses for repairs, property taxes, insurance and vacancies was around 70 percent of the gross, which in this case was roughly $12,600 annually.
At the time of purchase, the owner set up the standard IRS depreciation schedule of 27.5 years, which translated to an annual depreciation rate of 3.64 percent. Since depreciation can only be applied to the improvements and not the land, we estimated that the improvements made up approximately 75 percent, or $112,500, of the $150,000 value at the time of purchase. Based on those assumptions, the annual depreciation was around $4,095. We also assumed that the property would increase in value by 4.0 percent per year.
After a decade of ownership, the owner decided to sell. By that time, the property had increased in value by $72,000, to $222,000, and the mortgage had been paid down to $96,000. At the same time, the $150,000 basis for the property had been depreciated by $4,095 per year, or by $40,950 over the decade, to a new deprecated basis of $109,050. The IRS treated 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.
In addition to the 15 percent capital gains tax, the IRS also recaptured 25 percent of the $40,950 of depreciation that was taken over the years, for an additional tax bill of $10,238. The end result is that our investor was obligated to pay a total tax 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. Not included in our calculation is the New Mexico capital gains tax of up to 2.45 percent.
The seller realized a pre-tax profit of around $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 had to pay the IRS $27,181 out of the pre-tax profit, leaving an after-tax profit of $81,059. This is where the rubber typically hits the road.
The taxes are unavoidable if the plan is to sell and not invest in another income-producing property. Payment of the taxes can be postponed, however, if the seller invests in another like-kind property. The vehicle for that postponement can be found in IRS Code Section 1031.
In our example, the IRS will allow our seller to avoid paying 100 percent of the taxes if he or she trades or “exchanges” his property for another income-producing property as long as A) The exchange was set up prior to the sale of the property, B) The value of the replacement property is at or above the sales price of the property being sold, and C) The mortgage on the replacement property is at or above the amount of the mortgage balance on the property left behind. A shortfall in any of the categories will trigger a tax liability.
Exchanges come in three forms: A concurrent exchange, a delayed exchange, and a reverse exchange. I want to reiterate that exchange planning is serious business and is best accomplished by consulting a tax expert. How and when to effect an exchange is specific to each person’s tax situation so it’s difficult to address the possibilities here.
If you sold an investment property in 2019 and planned to replace it with another without first setting up an exchange, it’s too late to avoid paying the taxes. If you plan to sell this year, make sure you check with a tax professional or the IRS itself before moving forward. The money you save can be put to good use until it’s time to finally settle up.
See you at closing.
Gary Sandler is a full-time Realtor and president of Gary Sandler Inc., Realtors in Las Cruces. He loves to answer questions and can be reached at 575-642-2292 or Gary@GarySandler.com.