Q: My father-in-law is selling a duplex he rented out for about 10 years. The sale price is going to be around $300,000. His accountant says that he should plan on paying about $100,000 in taxes because he has depreciated the property and all the deductions (for things like repairs and new appliances) will be added back in for taxes.
Does this sound right to you? It seems to me that even assuming it was depreciated down to $0, a 33 percent tax rate is high. Can you give us any information on this?
A: Let’s start with the obvious: It does seem that paying $100,000 in tax on a property that sells for $300,000 is quite steep. You’ve left out a lot of important details when it comes to figuring out how the tax situation might play out, so we’re going to make some assumptions in order to fill in the missing pieces.
First, we're going to assume that your father-in-law purchased the property for around $200,000. In general terms this would mean that he would have a profit of about $100,000 on the sale of the building -- when you compare the purchase price to the sales price, excluding items that are allowable deductions, including the cost of purchase, the cost of upgrades and maintenance for an investment property, and the costs of sale.
If your father-in-law followed tax laws correctly, your accountant is right that your father-in-law would have depreciated his building over time. We don’t know how long he has owned the property and how long it has been a rental versus an owner-occupied home, but the typical piece of investment property is depreciated over 27.5 years.
Not everyone understands depreciation, but for income tax purposes the federal government allows you to say that something you owned has gone down in value each year you owned it. In your case, you take a $200,000 building and you say that the land was worth $50,000 and the building was worth $150,000. The IRS would allow you to offset income against the declining value (the depreciation) that the building has experienced (for tax purposes).
Remember, depreciation for tax purposes is one thing and the true market value of the property is quite another.
Your father-in-law's property might have skyrocketed in value while the IRS has allowed him to depreciate the property to zero. Here's the simplistic example: Your father-in-law paid $200,000 for a property that today could sell for $300,000. For IRS purposes, however, after depreciation, the property is worth $50,000 (according to the IRS) and the land is still worth $50,000, so the total property is worth $100,000. When your father-in-law sells the property, he'll have to pay tax on the profit and pay a tax on the amount depreciated over time.
If he depreciated the property $100,000 over the time he owned the duplex, the IRS may tax him at a rate of 25 percent or $25,000 for the depreciation he took. Then, let’s say he has a profit of around $100,000 on the sale of the building (sales price of $300,000 minus the $200,000 purchase price) and may have to pay a tax of around 30 percent on that amount or around $30,000. Finally, he might have to pay the 3.8 percent additional net investment income tax on the $100,000, or almost $4,000. Between these three taxes you’re at around $60,000 in federal income taxes; and then depending on the state in which you live, he might owe additional taxes there as well.
Your accountant may be estimating high, but then again, we’re just guessing at the numbers. So if our estimates are low and you have a state tax to pay, the actual total tax bill could reach $100,000. You have to remember, however, that the depreciation helped him when he filed his taxes all those years, and likely saved him thousands of dollars in taxes. The government only recaptures a quarter of that depreciation, so a typical real estate investor would wind up ahead of the game, even if it looks like there’s a big tax bill to pay now. (Your father-in-law’s accountant should be able to verify the years of tax savings for you.)
Lastly, you should know that if your father-in-law hasn’t yet closed on the sale of the property and is considering buying other investment real estate, he might want to consider a 1031 tax deferred exchange. This exchange is named after Section 1031 of the Internal Revenue Code, and it allows real estate investors to sell a property, reinvest all the proceeds from the sale of the property and buy a replacement property with those funds. By using a 1031 exchange, an investor defers paying all taxes on the sale of the property, including depreciation recapture taxes.
But the guidelines and rules are strict around 1031 exchanges. In the most basic terms, you must set up the exchange prior to the sale, never touch the money, find and designate a replacement property no later than 45 days following the closing or settlement of the property you sold, and close on the new property no later than 180 days following the closing or settlement of the property sold. You must also buy a new property for at least the same amount as the property you’re selling.
Not sure this will work for your family, but it might help dent that tax bill.
Ilyce Glink is the author of “100 Questions Every First-Time Home Buyer Should Ask” (4th Edition). She is also the CEO of Best Money Moves, an app that employers provide to employees to measure and dial down financial stress. Samuel J. Tamkin is a Chicago-based real estate attorney. Contact them through her website, ThinkGlink.com.