How Gain Calculations Work in a Taxable Transaction of Real Estate
Taxation of real estate gains includes understanding key concepts like basis, Section 1231 gains, and Section 1250 recapture.
Basis is the initial value of the property used to calculate gains or losses upon sale. Section 1231 gains benefit from long-term capital gains rates, while losses can offset ordinary income.
Section 1250 recapture taxes the depreciation taken during ownership at a 25% rate, higher than the usual capital gains rate. For instance, if a property purchased for $1 million with $200,000 depreciation sells for $1.1 million, the gain is $300,000 due to adjusted basis. This includes $200,000 taxed at 25% and $100,000 at 20%. Despite the higher recapture rate, depreciation provides significant initial tax savings.
For properties used in business, understanding these tax implications helps maximize benefits. Employing strategies like cost segregation studies can accelerate depreciation, enhancing tax efficiency.
Transcript:
Hey everyone, Stephen Morris here with AdviseRE, and today we're going to go over a brief topic on how taxation of real estate gains works and how the 1250 recapture works as well. Okay, so we're going to dive right into this. Now normally in our world in real estate, we love 1031 exchanges and we love not paying taxes on our gains. However, there might be times where it's very important for you to actually dispose of a property and have the cash physically in your bank account, right?
When we started off as developers, gosh, many, many years ago, we unfortunately had to sell all of our properties because we needed to build up our capital so that we could get into bigger projects later on. So we weren't able to use a 1031 exchange as our initial strategy, but as you start to mature as a real estate investor and you don't have such a high need for liquidity any longer, then of course 1031 exchanges are going to be right for you. But let's talk about how a gain, a straight gain on a property would work and what the tax implications of that are.
The first concept we're going to talk about is basis. Basis is a tax concept, and it's fundamentally a number that we're going to work with, which determines how much losses we can derive from a property, right? Generally speaking, our losses are limited to how much basis we have in a property. Basis is also the calculation used for determining what our gains are. The difference between the amount realized and the basis is going to be the amount recognized, which is your gain.
In the real estate world, gain is actually made up of two components. The first is section 1231 gains. Section 1231 provides for a combination of long-term capital gains, taxed at the long-term capital gains rate of 20%. If it's a loss, then the loss is ordinary and deductible against your W2 wages and other operating business income. The second component is the section 1250 recapture. Typically, in a property placed in service for rent, like an apartment building or shopping center, the landlord takes depreciation deductions every year during ownership. These losses are valuable because they generate ordinary losses, which could be as valuable as 37%, the top tax rate in the U.S. as of this video.
Every time depreciation is taken, the basis of the building decreases. Eventually, if you decide to sell the property, the sale amount will be compared to the adjusted basis. For example, if you buy a building for a million dollars and take $200,000 in depreciation, then sell the building for $1.1 million, you might think you made $100,000 in profit. However, in the tax world, because of the $200,000 depreciation deductions, your gain is actually $300,000—$1.1 million minus the $800,000 adjusted basis.
The way this gain works is it's split into two concepts. First, the section 1250 recapture—the $200,000 depreciation taken will be taxable at a long-term capital gains rate of 25%, a special rate just for 1250. The next $100,000 to make up the total $300,000 gain will be taxed at 20% or your applicable long-term capital gains rate. Let's assume 20% for argument's sake. The total of these two would result in your total long-term capital gains.
Let's consider another example. The same scenario, but the sale price is $900,000. In your mind, you lost $100,000 since you bought it for a million and sold it for $900,000. However, in the tax world, you have a $100,000 gain—$900,000 minus your adjusted basis of $800,000. All of this gain is attributable to depreciation, taxed at the 25% recapture rate.
That's generally how gains on taxable transactions in real estate work, particularly for real estate placed in service for trade or business, like rental properties. You might wonder, "Shouldn't I avoid depreciating it to avoid the 25% capital gains rate, which is higher than my long-term capital gains rate?" Remember that those deductions were ordinary when you took them, with a value of 37%. For every dollar of depreciation, you saved 37 cents, which comes back taxable at 25 cents—a permanent 12 cents per dollar tax savings. We love that outcome.
This is one reason we always encourage a cost segregation study in all our properties, to accelerate and maximize depreciation charges as quickly as possible. However, it depends on your personal tax situation. If you have any questions about whether this strategy applies to you, contact us here at this email, and we're happy to discuss how you can achieve this outcome.
Thanks so much for joining, and we look forward to seeing you in our next video.
