In previous articles, I’ve detailed each stage in the life cycle of a rental property (purchase, rehab, monthly work, and disposition). In this article, I wanted to piece together the entire life cycle of a rental property. I will only be discussing traditional rental property (i.e. no house hacking).
Before we start, please see the key terms that will be discussed.
- Depreciation - paper expense for purchasing property (one of the biggest advantages for RE)
- Ordinary - costs typically incurred within your industry
- Necessary - costs you must incur to fulfill your mission or purpose as a business operation
- Depreciation recapture - upon sale, you must recoup your depreciation cost taken for the rental property and pay up to a 25% tax
- Adjusted basis = purchase price - depreciation expense taken during period of ownership
- 1031 Exchange = Allows you to avoid paying capital gains taxes when you sell an investment property and reinvest the proceeds from sale.
- Other key items
- Purchase price for new property must equal or exceed the net sales price of the other properties.
- Total amount of cash (net equity) you fund into your replacement property must equal or exceed the net equity you receive from relinquished property
- Other key items
- Net equity
- Seller Formula
- Sales price - closing costs - mortgage principal paid off at sale
- Buyer Formula
- Purchase price + purchase closing costs - new loan balance
- Seller Formula
I’ve mentioned it before and I’ll keep harping on this point. With the purchase, the most important thing is figuring out your basis. The basis is important for determining your depreciation deduction. This article will help you figure out your basis in the building.
Once you figure out your basis, you must figure out between building and land. The two most common ways are to go to your assessor’s website or go to your appraisal. See my first article which provides a nice example of this.
Sometimes investors purchase turnkey assets. If that’s the case and if you’re one of those investors, feel free to skip this section. For the rest of the people that are looking to have forced appreciation on a property, this section is for you.
The biggest item to note here is that you have to keep track of all items you have put into your building. This can range from improvements (upgrading plumbing and electrical, upgrading the structure, etc) to land improvements (parking pads for tenants to park their vehicles), and even appliance replacement. You will want to make sure to categorize these based upon what the IRS classifies as useful lives, and make sure the appropriate depreciation deduction is being taken. The IRS property classes are on page 29 of their website.
You will also want to note that if there are assets less than 20 years in useful life. You can take bonus depreciation (all of the depreciation in year one instead of spreading this out over its useful life). Examples would be land improvements and appliances. You want to talk with your accountant regarding your specific situation as there may or may not be a significant benefit to taking the additional depreciation during the year.
It is important to keep track of income and expenses on a monthly basis. This ensures that you’re not forgetting about potential deductions. I want to make this very clear. It is YOUR responsibility to keep accurate records for your rental properties. Each property must be accounted for separately. It is your tax preparer’s responsibility to (a) fill in the categories on Schedule E (below) and (b) ask good questions to uncover additional deductions/get everything right. I understand that keeping track of your income and expenses is onerous on a monthly basis but it’s a lot better than missing out on valuable deductions.
Sale of Property
Upon sale, there are certain tax consequences including depreciation recapture and paying capital gains (should you not decide to do a 1031 exchange). To best illustrate this point, I will run through one example where an investor opts to sell the property outright and take the money. The other example will be an investor utilizing a 1031 exchange to defer tax. You will be able to clearly see the tax implications of each approach.
Example 1: Sale of property and no additional property is purchased
An investor purchased property for $500,000 in year 1. In year 10, you have taken approximately $150,000 in depreciation (adjusted basis of $350,000). You opt to sell for $700,000 (after all fees and expenses).
The tax consequences are
- Gain on sale =$ 700,000 - $350,000 (adjusted basis) = $350,000
- Of that $350,000, $150,000 will be taxed at the lower of ordinary income rates or 25%. For simple math, let’s say it’s 25%. The remaining is taxed at long term capital gains rates (typically 15-20% as of right now)
- Taxes owed - total of $67,500
- $150,000 (depreciation recapture component) * 25% = $37,500
- $200,000 (remaining gain) * 15% = $30,000
Example 2: Sale of property and additional property is purchased
Let’s assume the facts are the same example as #1 and they had a $350,000 mortgage. The first thing we must do is calculate the net equity (defined above). The net equity of the seller is:
$700,000 (Sales price) - $350,000 (mortgage principal balance paid off) = $350,000
The seller purchased a property for $1.5M that’s a suitable rental property and is similar to the one sold. The $1.5M property was able to be purchased with 25% down, leaving a mortgage of $1.125M. As such, the net equity is $375,000.
As such, all gains are deferred because:
- The purchase price of the new property ($1.5M) is higher than the sales price of the old property ($700k)
- Net equity of the new place ($375k) is higher than the net equity of the old property ($350k)
As such, the total tax savings is $67,500. The main item to note is that the new basis would be reduced by the gain on sale. The new basis would be $1.15M (1.5M - $350k).
Wrapping it Up
When you purchase your property, it is just the beginning of the additional tax fun. There are many tasks that the investor must undertake or outsource during the time of ownership (ensure basis is correct, keeping track of rehab costs, monthly bookkeeping,, etc). Upon sale, there’s typically a decision that needs to be made: sell the property (keep the cash, pay the tax), or roll the money into a 1031 exchange (add a property, defer the tax). My hope is that the above clearly illustrates the important concepts for your rental property and for whatever stage you are in.
If you have questions on your real estate tax strategy, you can reach me (Aaron Zimmerman) at email@example.com.
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