Sale of Real Estate

There is often a hidden surprise (not in a good way) when we talk about the sale of rental or otherwise business real estate. The typical type of question I get from clients is along the lines of “I bought this rental property 10 years ago for $300,000, and I am going to be selling it for $500,000. Obviously I have a $200,000 gain – what’s my tax”? Ah, were life only that simple.

In almost all likelihood, what my client left out (probably really didn’t know) was the issue of the extent of the depreciation taken on that property over those past 10 years. So, the rental property cost $300,000; let’s assume that $100,000 was assigned to the value of the land, and $200,000 was assigned to the building. That property was rented, and reflected on the tax returns of the individual. One of the expenses taken against that property, allowed under our tax laws, is something called depreciation (essentially the writing off of the cost of the property). Let’s assume that over those past 10 years depreciation has been taken to the extent of say $80,000. Now you're selling the property.

This is when those previous tax write-offs come back at you. From a tax point of view, writing off $80,000 for depreciation means that you lowered your cost in this property for tax purposes by $80,000 – which means that you’ve got $80,000 more of gains than you thought you did. Thus, you don’t have $200,000 of taxable gains – you have $280,000 of taxable gains. And, to make matters somewhat worse, while the $200,000 of gain is taxed at capital gains rates, the $80,000 is taxed at special depreciation recapture rates – which are better than the regular rates but worse than the capital gains rates.

Finally, a few words relevant to cash flow from the sale. From a tax point of view, there is absolutely no connection between the cash you get from the sale and the taxable issues. A common situation is a property has been mortgaged, remortgaged and refinanced. The property is sold, and net of the mortgages of course, you get your cash. It is not unusual for the mortgage at that time to have exceeded your cost basis in the property – and thus the cash you get can be considerably less than the gain. In some extreme cases, we have people selling real estate with an income tax bill exceeding the cash flow.

If you have any questions contact Kal Barson at kal@barsongroup.com