Many of us have heard that the real estate market is currently a “sellers” market and that property values are skyrocketing to new highs. In Louisville, home values have increased by about 35% over the past 5 years and are projected to increase an additional 10% this year. This may have you thinking about selling a property; however, before doing so, it is important to understand the tax consequences, especially considering that taxes are likely one of the biggest items associated with the sale and may result in you receiving a lower net amount than you were hoping. In this article, we will discuss the consequences of selling a primary residence, a second residence or vacation property, or a rental property.
If you are selling your personal residence, you likely will not owe tax due to the home gain exclusion available for primary residences; however, this is not true in the below circumstances:
- Gain is over $500,000 Married Filing Jointly (MFJ) or $250,000 Single
- You have deducted a home office on your tax returns
- You have not lived in your home for at least 2 of the last 5 years
If you are selling a second residence which has not been your primary, or if you have appreciation in excess of the excludable amounts, any appreciation will be taxed at capital gain rates. Under current tax regulations, the Federal capital gain rate is anywhere between 0% and 23.8% depending on your taxable income. An additional 5% tax will apply for Kentucky and an additional 2.2% if the property is located within the Louisville Metro. In total, your tax rate on capital gains will range from 7.2% to 31%.
This income exclusion is not available for rental properties or properties acquired for intention of developing and flipping. In addition, gain on the sale of rental properties can be split into 3 different categories – Section 1231, Section 1245, and Section 1250. Ordinary rates apply on any furniture and equipment which have been depreciated up to the amount of depreciation allowed or allowable since placed into service. If the furniture and equipment appreciated in value, the appreciation which is the difference between the amount you paid and the amount you are allocating to these assets is subject to capital gain rates. Currently, ordinary income rates range from 10% to 37%.
Section 1250 is actually a subset of capital gains subject to a maximum federal tax rate of 28.8% (25% rate applicable to Section 1250 property plus the additional Medicare tax of 3.8% which is applicable to any investment income. Section 1250 property includes buildings, building improvements, and depreciable land improvements. Similar to furniture and equipment, the special rate of 25% only applies to the extent of depreciation which has been allowed or allowable. Any appreciation is subject to capital gains tax rates. Land is not depreciable and is classified as Section 1231 property. Any gain allocated to land is subject to capital gains tax rates.
The term allowed or allowable was referenced a couple times in the previous paragraphs. Before proceeding, it is important to understand this term. Once an asset is placed into service, the property should be depreciated in accordance with current IRS regulations. Current IRS regulations specify that furniture and equipment be fully depreciated in the year of purchase using bonus depreciation; therefore, if furniture and equipment were placed into service and not depreciated, the furniture and equipment is deemed to be fully depreciated even if depreciation was not deducted on the tax return. Allowed or allowable also applies to any other depreciable asset. For instance, if an owner started renting their home in 2017 and the property was not depreciated until 2020, the owner will lose the depreciation on the home which should have been deducted between 2017 and 2019. This is one reason why it is critical to have good records when you have rental property and carefully consider all considerations of converting your residential property into rental real estate.
If you are hoping to sell the rental property and invest the proceeds into a different rental property, you may still be able to exclude the gain in accordance with the current like kind exchange regulations (IRS Section 1031). This is often used by rental property investors looking to purchase a rental property closer to their home or those wanting to consolidate multiple rental properties into a single rental property. A like kind exchange needs to be planned so that it satisfies all the requirements. If you sell the property, you are not able to receive the proceeds and then decide to invest in a different property. Any cash or reduction in debt as a result of the exchange is taxable.
One additional category of real estate includes properties that were purchased with the intention of developing or flipping falls. Income generated from this category is ordinary income. In addition to not being subject to beneficial rates upon disposition, these properties also do not qualify for income deferral under like kind exchange regulations as the properties are treated similarly to inventory as opposed to real estate purchased with the intention of holding long term. The primary tax consideration in this area is the deductibility of expenses as well as the timing of such deductions.
Within the current proposed tax plan, like kind exchanges and capital gain rates are considered to be potential revenue raisers. While it is still uncertain what will actually be passed, the removal of these benefits may provide an additional reason to go ahead and sell a rental property. The current proposed regulations reduce the potential deferral of like kind exchanges to $500,000 per taxpayer and subject capital gains to ordinary rates for those making in excess of $1 million.
In summary, the high property values may have you thinking about selling your real estate; however, before doing so, we recommend considering all of the tax consequences as well as verifying that the transaction is properly structured. If you need assistance with these considerations, please reach out to us for assistance.