what's going on alex here and today i'm
going to be talking about the income tax
implications of selling a real estate
rental property
and i'm going to be taking a look at the
entire lifecycle from the purchase of
the property
to depreciating it while you own it and
have it used as a rental
and finally the sale when you dispose of
the property
and we're going to be taking a look at a
pretty detailed example that i prepared
for you
so you can get an understanding exactly
from a to z how all of this works
without further ado let's take a look
all right so
i set this example up so that we can
understand line by line what's going on
and it's going to really start at that
purchase date when you acquire
this rental property and we're going to
assume that this is a residential
rental property that we're talking about
and the reason
there's the distinction is that
residential
rental property is depreciated over a
different time period than commercial
real estate property that's really the
only difference everything else here
would be generally applicable to both
residential and commercial
and take a look at the example here we
have the property purchase information
and you'll see that these sections
are divided sort of in a timeline basis
so you
start here and pretty much work your way
down now we have the property purchase
okay so we're going to assume the
acquisition cost of a million dollars
and the purchase date of 1 1 2016.
simple enough so far right okay so now
for tax purposes it's crucial that we
figure out the
cost basis and what that means is
we need to separate out that acquisition
cost of the million dollars
between what's attributable to the
building and what's attributable to the
land
the reason that we do that is because we
can depreciate the building meaning we
can take depreciation deductions
on an annual basis for the building but
not the land land is not depreciable
so we need to know right from the onset
how much
of the acquisition cost is attributable
to the building versus the land
and this is why we take this next step
that i outline here
now in terms of figuring out how much of
the acquisition cost
is applicable to the building versus the
land sometimes it's useful to look
at the appraisal because that should
have
pretty simple delineation between
building and land
it shouldn't be hard to figure it out
from there but it's often the case that
an appraisal is not available for
whatever reason and we have to rely on
property tax
statements now we have to be very
careful here
and understand that the values that
are shown on the property tax statements
not what we're looking for right
the reason being that every city and
every municipality out there
has a different formula for calculating
the assessed value and it may not at all
represent the fair market value of the
property
so the important thing to keep in mind
is in this example if we're looking at
the property tax statement
the assessed value for improvements also
known as
the building is three hundred thousand
the land is one hundred thousand the
total assessed value is four hundred
thousand
but wait a minute we just talked about
the acquisition cost being a million
what's going on
that's because this assessed value is
not what we're going to take into
account but
what we are looking for is the
percentage allocation
between the building and the land that's
the important part that we're taking
from the property tax statement don't
take the assessed value as the fair
market value that's a big no-no
and you're going to find yourself in
trouble if you do that because it
doesn't necessarily reflect fair market
value of anything
again in a thousand municipalities you
can have a thousand different formulas
on how to figure out the assessed value
so what we're looking for is the
percentage allocation really important
and we can see that out of the total
assessed value of 400
000 we have three hundred thousand in
improvements or the building
and we have a hundred thousand for the
land and what that tells us is that
seventy-five percent
of the assessed values attributable to
the building versus twenty-five percent
for the land
that's the information that we want to
garner from
the property tax statement again not the
assessed values don't try to calculate
depreciation on this
you're going to go sideways it's not
going to be a good time
all right so again these blue highlight
lighted areas are from those
property tax statements and at this
point i did want to also mention the
fact that
you may want to consider a cost
segregation study
because that may allow you to accelerate
some of the depreciation that may be
applicable
to the building portion of the property
and some of the personal property that
may be there so something to look into
that's why i thought i would mention
that cost segregation study
is something that you can put in place
to accelerate some of those
depreciation deductions in some
situations
all right so now we did the work of
allocating
the cost between the building and the
land in terms of figuring out the
percentages but now
let's do the actual math to get the cost
basis amounts figured out
so again total acquisition cost million
dollars
now we have the building which is also
known as a section 1250
asset we don't need to get super
technical about this but section 1250
refers to section 1250 of the internal
revenue code
and that has to do with buildings that
are
depreciable for tax purposes so we refer
to the building as section 1250 property
it's sort of synonymous all right
and out of the million we know that
75 percent is allocable to the building
so we have
75 percent of the million being 750 000.
similarly the remaining basis is
allocated to the land so that's 25
just as noted here and we get the total
basis being a million dollars so now
we've allocated using the property tax
percentages property tax statement
percentages
we've now allocated the cost basis for
the property between the building and
land
why is that important it's because we
now know
the amount that we're going to use to
calculate depreciation
on the building right so when we just
had the million dollar purchase price we
have no idea
what the amount is that we start with
for purposes of depreciating the
building is it 800 000
is it 500 000 who knows and
when the appraisal is not available we
can use that allocation between
the building and the land per the
property tax
statement you just want to make sure
it's a recent one because that will be
the most reflective of the situation at
that time all right
so and when i say most recent right
around the
acquisition date all right okay
so moving along we've got our cost basis
calculated
how is this beneficial at this point now
we know the basis
which is going to be used for purposes
of calculating depreciation
now what's depreciation all about
depreciation is a
non-cash expense it's an expense that
just happens without you having to reach
into your pocket and spend money
after the purchase of the property and
it allows you to essentially recognize
that the property
is being used up over time there's wear
and tear and so forth so
in that case that is the idea of
depreciation okay
and we need to know the start date
for that depreciation deduction okay in
this case we're going to assume that the
property was rented from day one it was
purchased with the intent of it being a
rental property so we have one one
2016 as the date placed in service
really important for depreciation
purposes
then we recognize that the depreciable
life
for residential rental property is 27
and a half years for the building
portion now i mentioned before that if
you're talking about commercial real
estate the only real difference
is that you'd be using 39 years as the
depreciable life
for the building with commercial real
estate with residential we're using 27
and a half years so i do want to make
that distinction so
it's clear if you want to apply this to
a commercial application
all right so let's recall the total
basis for the building that we assigned
here
is 750 000 we're just rolling forward
those amounts so
they stay fresh in our memory and we
calculate the depreciation per month
at 750 divided by the 27.5 years divided
by
12 months 12 months in a year you can
see the formula there
and we get the depreciation per month of
2272.73
fair enough so now we're going through
2016
we're renting out this property we're
having a great time and we need to
calculate the depreciation
now there is a convention
applicable to rental property that's
known as the mid-month convention
and what it basically says is that if
you put
a property into service on let's say the
3rd of january versus the 27th of
january
the tax code really doesn't care about
that they're going to assume that
whether you put it in service on
the third or the 27th that you placed
into service
on the 15th on the middle of the month
in which you placed it into service
that's
the nature of the mid-month convention
and if we place the property into
service on the
first of january 2016 for income tax
purposes it's going to be assumed
that we actually placed it into service
in the middle of january
so it would be 1 15 2016
and that's why the depreciation
deduction is reflecting 11 and a half
months in that first year all right so
the subsequent years
for example 2017 and 18 they're going to
reflect 12 months of depreciation
a piece but 2016 since it's the
first month in which the property was
placed into service
being that january of 2016 you get half
of that month all right
and again that's due to the mid month
convention so we have 26
136 about 36 calculated in depreciation
for 2016.
for 2017 you'll see my formula that it's
taking that monthly depreciation and
multiplying it by 12
because again we didn't place the asset
into service in 2017 so we get 12 whole
months
of depreciation for 2017.
2018 is the same story and
you'll see that it matches 2017 in terms
of depreciation so we're all good
now we want to calculate the accumulated
depreciation as of 1
1 2019 and the reason we want to do that
is because we're going to assume that we
sold this property
in may of 2019. so we want to know as of
the beginning of the year how much total
depreciation do we have
and that answer is 80 681
all right so hopefully you guys are all
following so far all we did so far
is purchase the property get the cost
basis applicable to the building and
land
and now we're just having fun
depreciating it all right
so now we get to the sale of the
property
this is what you've all been waiting for
drum roll please in terms of
the sale details we're going to assume a
sale date of
may 1st 2019 and the total sale proceeds
or the total sale price is 1.5 million
now we all know that we have to pay our
real estate agents right
and because of that i assumed a six
percent real estate commission
maybe high may be low but you get the
dynamic of how it affects the
calculations that's the important part
all right so that's 90 000 it's just six
percent of that 1.5 million and you'll
see why that's important later on
now we need to allocate the sale
proceeds
between the building and the land
just as we did with the cost basis so
believe it or not
and it'll make more sense as i go
through this example but we have to
essentially treat the sale of the
building versus the sale of the land
as separate transactions we have to
allocate the proceeds accordingly
selling costs and so forth to figure out
the respective gains in each category
why do we have to do all that work
the reason is that the tax code is set
up in such a way
to tax any gains attributable to
depreciation
at a different rate than standard
long-term gains
don't worry if i lost you there i'm
going to backtrack on it and make it
make sense
so basically let's say you purchase an
asset for a hundred thousand dollars
right
and you start depreciating and
depreciating and depreciating all the
way down to
let's say zero it's possible and then
you sell it for thirty thousand
all right now what happened was congress
was
very nice and they said you know you
could depreciate that asset down to zero
even though it's probably worth 30 000
just
take the depreciation and what happened
that depreciation
typically offsets ordinary income in
some cases
so you're getting pretty significant tax
benefit by
depreciating it down below its fair
market value
all the way to zero we know maybe worth
30 but you get to go all the way to zero
so that's
sort of a gracious area of the tax code
where they just give you a freebie they
say hey just take it all the way down
but then when you sell the asset for
let's say thirty thousand
let's remember the basis is at zero
because of depreciation
and you sell it at 30 000 that
difference now
congress wants to say hey you might have
deducted
that depreciation at the 37 bracket
now we want it back up to 25
all right and that is something called
section 1250
unrecaptured gain and
taxpayers get angry at this all the time
because they feel like
oh well the section 1250 unrecaptured
gain can be taxed at up to 25
at the federal level that's more than
the long-term capital gains rate of
maximum 20 percent okay but the other
argument
is that you received depreciation
deductions
at let's say the 37 bracket and now
congress is only asking you to pay up to
25 when you
actually sold that asset so depending on
how you look at it obviously nobody
likes to pay more in taxes but
there is a sort of a rhyme and a reason
to all of this madness
and getting back to our example we need
to allocate between the building
and the land because we need to
determine what amount of the gain if any
is section 1250 on recaptured gain
the reason being is that it's taxed at
up to 25
at the federal level whereas long-term
capital gains rate
maxes out at 20 percent so it's a bit of
a different tax treatment bit of a
different tax flavor
we need to calculate that section 1250
unrecaptured gain
that's why we need to split the building
and the land if you
smush it all together you may
miscalculate the
gain and the nature of the gain being
that your section 1250 gain might be
off might be overstated and so forth so
uh definitely want to make sure you
treat
the building and the land separately all
right
so in terms of allocating the sale
proceeds
again we want to reference the
property tax statements now again this
is in absence
of an appraisal we can look at the
property tax statements
similarly we don't look at the assessed
values at this point at that sale date
in 2019
we want to know the percentage
allocation between the building
and the land because we need to separate
these transactions again we need to know
how much of the proceeds to allocate to
building versus land
that's one way to do it if you have your
appraisal even better you use the
appraisal
but if you have property tax statement
as of
a date very close to the sale date you
may be able to use that
and focus on the percentage allocation
between the building
and the land and in this case we'll see
that it changes a little bit from when
we
first purchased the property because now
the improvements
are four hundred thousand land is at two
hundred thousand total assessed value is
six hundred thousand so the improvements
or the building
portion is sixty six point six seven
percent and the land is thirty three
point three three percent
why is this important it's important
because those are the percentages that
we use
to then allocate the proceeds between
the building and the land that's the
first step in calculating the gains
in each of those areas so we have
1.5 million as the total proceeds we
use these percentages and we arrive at 1
million
being the allocation of the sales
proceeds to the building
and 500 000 being the allocation to the
land
all right so total of 1.5 million but
that is the starting point for us to
calculate
these gains and the nature of the gains
and so forth
now we also make the same allocation to
selling costs now we talked about the
real estate commissions being
ninety thousand the six percent of the
1.5 million
and again we use these same percentages
to allocate
the selling costs for the building
versus selling costs for the land again
we have the same
90 000 here as we go through
we want to calculate the implications
for the building so let's take a look
now the accumulated depreciation
as of 1 1 2019 was 80 08 681 spot 82. we
talked about that
all the way up here same number okay
and the depreciation for texture 2019 is
4.5 months
we start with the accumulated
depreciation as of 1 1
2019 of 80 000 680 once by 82.
this amount comes from up here so it
should be pretty familiar
all right and now we have to calculate
the depreciation for tax year 2019
being 4.5 months why is that because
we're selling the property on
may 1st 2019 we have the sale date here
so due to the mid month convention
it's still assumed that we're selling it
on may 15
2019 so we have january
february march april and then half of
may so four and a half months
is the amount of depreciation that we
need to take here
and we need to remember that the monthly
depreciation was 22
72 spot 73 and we multiply that by four
and a half
we get the depreciation for 2019 of 10
000
227 spot 27. we add all those together
we get 90 0909 spot 09 that is the total
accumulated depreciation
as of 5 1 2019
all right or at least that's the amount
of depreciation that would be taken into
account with
5 1 2019 as the sale date for this
property
all right so moving along we want to
also
look at the cost basis allocated to the
building that was
750 000 that comes from here
all right so it should look familiar and
the total accumulated depreciation
we talked about was 90 0909 so we get
the adjusted basis for the building
of 659.09 no spot 91
that's really as of the sale date
essentially so that's the adjusted basis
that we're gonna use for purposes of
calculating
the gain or a loss but in this case gain
on the sale
now we talked about separating the
purchase into essentially two
transactions the reason we're doing that
is because really the tax code the
directions tell us to
and here's an excerpt from the irs
publications here and it is titled as
follows depreciable property and other
property disposed of in the same
transaction
if you dispose of both depreciable
property and other property for example
a building and land
in the same transaction and realize the
gain you must allocate the amount
realized between the two types of
property based on their respective fair
market values
to figure the part of the gain to be
recaptured as ordinary income because of
depreciation
that's that section 1250 unrecaptured
gain that they're referring to
the this position of each type of
property is reported separately in the
appropriate part of form 4797
for example for property held more than
one year report the sale of the building
in part three and land in part one
and i'm going to show you exactly what
that looks like in a minute
but this is where we get some of this
insanity from
the directions tell us to do it that way
all right so let's take a look at the
analysis applicable to form 4797 part 3
and this has to do with the building and
i can just tell you that
we're gonna show you the actual tax
forms
and what they look like and this should
look very familiar for you
all right so the gross sales price
attributable to the building is a
million dollars again we get that
from here and the cost or other
basis plus expense of sale is simply the
cost basis allocated to the building
plus
the allocation of selling costs right we
talked about
allocating everything between the two
sales the trading has two different
sales
now we have the depreciation of 90
0909 spot 09 that's right from
here okay and we have the adjusted basis
being the cost or other basis minus that
depreciation amount
that's what gives us the adjusted basis
the total gain on the building portion
is 280 909.09
all right and of that we have
section 1250 unrecaptured gain of 90
0909 spot 09.
all right so all the depreciation that
we took since the gain is higher than
all that depreciation
then it's all going to be recognized as
section 1250 unrecaptured gain
now let's look at the land portion
so now we're talking about form 4797
part 1.
the gross sales price that was allocated
was 500 000
where did that come from right here okay
all right and now we have the cost plus
other bases plus
expense of sales so cost or other basis
comes from right here 250 000
plus the 30 000 and that gives us 280.
now the depreciation on the land is zero
why is that
you know why because we don't depreciate
land right land is never depreciated so
that's zero
so the adjusted basis is then 280 the
total gain is
220 000 dollars there's no section 1250
unrecaptured gain
attributable to land because there's no
depreciation so the long-term capital
gain that we're dealing with there is
220 000
putting all this together we have the
long-term capital gain on the building
of 190 000
we have the long-term capital gain on
the land of 220 000
we have section 1250 unrecaptured gain
of 90
0909 spot 09. so that gives us total
long-term capital gains of 500 0909 spot
09.
okay and it's important to
keep in mind that section 1250
unrecaptured gain
is considered to be included within this
long-term capital gains amount so when
you look at the return you're going to
see
this amount of gains but also hiding in
there is going to be section 1250
on recaptured gains and now we're going
to take a look at the tax returns
so you can see an example of this
scenario playing out
in tax year 2019 which is the year of
the sale fair enough
all right so let's pull up the
tax software here and we have a simple
form 1040 set up
and let me make it so you guys can see
this
all right and the idea is to just have
this transaction isolated so we can take
a look at its effect so this is a form
1040 2019 single filing status
no big deal and let's take a look at
form 4797
let's see if i could put these side by
side and just before i
minimize this screen you'll see that
it's the building that we're dealing
with
it was place and service in one one 2016
it was sold on five one 2019
and you'll see some of these amounts
they should look familiar
because just take a look here how we can
view this for you
okay so hopefully this is visible
but the idea is that you have
the form 4797 essentially recreated
in the spreadsheet okay so we have the
gross sales
price of a million we have the cost
or other basis plus expense of sale of
the 810
we have depreciation allowed or
allowable 90 000 909.09 there's a
slight rounding error there no big deal
adjusted basis
719092 versus 709.090 again
rounding so the total gain is 280 0909
or 908 again rounding errors
so that is how the
part three of form 4797 is put together
this is where all the amounts are coming
from i showed you where
they all originate how they're
calculated so that's how you'd approach
the completion of part 3 of 47.97
attributable to the building
okay now on the other hand
we go to part 1 of 4797
and here we have the sale of the land
to account for and this is a little bit
more straightforward and as the
instructions told us
we want to report the sale of the land
here in part one now let's go to the
land sale
all right and you can see here a lot of
these numbers should look familiar
because you have the 500 000 gross sale
price
there's no depreciation it's land cost
or other bases plus expensive sale is
280
so we have a gain of 220 000
all right and the total gain 500
908 500 909 no big deal rounding
but you get where that's coming from and
how it's being calculated
all right so let's take a look at some
other sections of the return to see how
these numbers are all rolling through
and in particular i wanted to take a
look
at schedule d all right so
over here we have nothing in the
short-term gains area let's see if i
could zoom in here
and you can see in the long-term capital
gains area
we have 500 0908
all right and we talked about the
long-term capital gains encompassing
those section 1250 unrecaptured gains
okay that's why you're seeing that total
amount
but if we go to page two of schedule d
we see that on line 19 for 2019
unrecaptured section 1250 gain
is 90908 all right
there's another place where that shows
up and
that is in the worksheet for schedule d
let's take a look at that
all right again there's a unrecaptured
section 1250 gain worksheet we have 90
0908
agrees to our numbers that's good now if
we look at
the scheduled tax worksheet
we can see all sorts of different
craziness going on here but what we want
to focus on
in particular is on page two
there are a few different rates here
that are denoted one of them
is on line 40 you can see multiply line
39 by 25 percent
all right but there's nothing here
what's happening
i said earlier in this video that
section 1250 unrecaptured gains are
taxable
up to 25 at the federal level but that's
not what we're seeing here we're seeing
here that that's not
the case the reason being is that
it's up to 25 percent not necessarily 25
but the income overall has to be high
enough
to hit that maximum 25 rate on the
section 1250 on unrecaptured gain
so let's add some income and see what
happens
in this case i'm just going to add some
interest income all right
very basic stuff so let's just add 200
000 in interest income it doesn't have
to be interest could be wages could be
any
other sort of ordinary income and as
long as it's taxable
and looking at the same worksheet
look what happened now
you see that 25 rate being applied
to the section 1250 unrecaptured gains
all right so it's up to 25
there's a lot of websites out there that
say oh it's 25 it's not
the rate for every transaction it's only
applicable if income is high enough
to reach that threshold of being taxed
at 25
but it's very possible that if it's just
significant income or significant gains
you're looking at that 25 maximum rate
being applicable
for that depreciation portion or the
gains attributable
to the depreciation all right and that
is essentially how it all
plays out okay so looking at the 1040
let's just see where this all rolls into
all right and you'll see that the
capital gain amount we talked about is
500
908 and you won't see on the 1040 itself
that all these different values are
being broken out but
you're gonna see that on schedule d on
the schedule d worksheets on the 4797
all these details spelled out so you do
have to include a lot of this
information on the return
you can't just skip it and hope for the
best it's all important it's all
applicable
and i hope this video allows you to
understand the mechanics
of how all this comes together
now some additional considerations
before i wrap this up
estimated income tax payments if you
sell a real estate rental property
throughout the year
it may very well be the case that due to
the gains involved you will have to make
estimated income tax payments to ensure
that you can minimize
penalties and interest because your
total tax liability might jump
up in the middle of the year and you
want to pay that in over time instead of
when you file the return to minimize
penalties and interest sometimes
taxpayers are surprised
by the fact that they needed to make
estimated income tax payments how do you
determine that
you have a qualified professional put
some projections together for you
to really try to project what your 2019
or 2020 returns
or whatever tax year might look like
when all is said and done
because that's going to allow them to
understand the total tax liability
versus what you paid in and what was
withheld
the difference is going to need to be
bridged by estimated tax payments or you
could pay when you file your return but
just be aware that you're probably going
to pay
penalties and interest as well another
thing to keep in mind is if you're
selling
real estate rental properties you may be
able to defer some or all of the gain
recognition
to a later time by putting in place a
like kind exchange this is also known as
a 1031 exchange
and it may be a very useful tool in
kicking the gain bucket
way down the road to ensure that you
don't have to deal with gains in a
particular year but you can defer them
to
a later year now like kind exchanges can
be a college course
in and of themselves so i'm not going to
get into it in this video but it's
something to consider
if you're looking to sell a real estate
rental property and you want to reinvest
those funds in real estate
that's something to think about so
overall
the idea here was to really take you
guys through the process help you
understand where these amounts come from
and some of the calculations that are
done behind the scenes by your
beloved tax preparers that you may not
even know are happening
but this is really how we take into
account the sale of
real estate rental property there really
isn't a shortcut way to do it this is
what we have to go through
and aside from this we also need to
consider all those other crazy amounts
that are included on your
hud 1 closing statements right because
there's about 50 different numbers on
there that needs to be taken into
account one way or the other
so a lot of different things i threw at
you guys
but just understand that there are
a few steps that you need to take about
the life cycle of owning a property
that will be important as you rent that
property
and take depreciation deductions and
subsequently
sell it all right so if you found this
video helpful
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and with that if you have any questions
feel free to reach out
as always hopefully this was helpful
thanks for watching