Q: What are the income tax consequences of selling my residential rental property in 2013? I purchased the property in Gold River in 1997 for $255,000. It was my primary residence until 2006 at which time it became my rental property. Its value in 2006 was approximately $525,000. I sold it in 2013 for $420,000.
During the 7+ years as a rental, I depreciated the property on my income taxes each year. I made no major improvements or other changes during the 16 years that I owned the property. Is there a way to avoid, minimize or shelter the income taxes that will be due in 2013?
A: The general rule for sales of assets is that the gain is taxable unless there is a specific Internal Revenue Code section that provides for an exclusion.
There is an exclusion for the gain from the sale of a person's principal residence, but it does not apply unless the owner has lived in the residence for at least 2 of the last 5 years prior to the date of sale. Based on the facts in your question, it does not look like this exclusion applies, so the gain will be taxable.
Since the residence was used as a rental for a number of years, and subject to depreciation deductions, you will have two types of gain, each taxed at different rates. To the extent that the gain is due to the depreciation expense taken in the past, it will be taxed at 25%. To the extent that the gain exceeds the accumulated depreciation deductions, it will be taxed as a long-term capital gain.
For sales in 2013, if you are in the 10% or 15% federal tax bracket, the tax rate on the long-term capital gain is 0%; if you are in the 25%, 28%, 33% or 35% bracket, the capital gain tax rate is 15%; if you are in the 39.6% bracket the rate applied to capital gain is 20%. You can find the 2013 federal brackets at http://taxfoundation.org/blog/2013-tax-brackets.
In addition to the regular income taxes described above, the gain from the sale of the rental may be subject to the 3.8% medicare surtax on "net investment income." Net investment income includes gain from the sale of assets held in a "passive activity," such as a residential rental. The surtax applies if your "modified adjusted gross income" exceeds certain threshold levels. For single and head-of-household taxpayers the threshold is $200,000. For married taxpayers filing joint returns the threshold is $250,000. For married taxpayers filing separate returns the threshold is $125,000. The 3.8% tax applies to the lesser of "net investment income" or the amount your "modified adjusted gross income" exceeds the applicable threshold.
There are strategies for deferring or reducing the gain from the sale of real properties. The first is the "Section 1031 exchange," named after the IRS section that allows it. If you identify and acquire "like-kind" property replacing the property you disposed of within certain time periods, you can defer the gain from the disposition of the first property.
There are a number of rules and non-extendable deadlines that apply to this type of exchange, so you should consult with your tax advisor before entering into disposition of the first property. Since your question indicates that you have sold the property, I am going to assume that it is too late to use a "Section 1031 exchange" at this point.
Another strategy that sellers of real estate can use to defer gain is the installment sale. In an installment sale, the seller finances some or all of the purchase price by taking a mortgage note as part (or all) of the selling proceeds. Gain is recognized to as the principal on the mortgage note is received, except for the portion of the gain attributable to depreciation. That part of the gain has to be recognized in the year of sale. Similar to the "like-kind exchange," this approach has to be put in place before the sale occurs.
You can also offset the gain from the sale of the dwelling with losses from the sale of other assets held for investment. If you own investment real estate, mutual funds, stocks, or bonds that have decreased in value below their original tax basis (usually their purchase cost), selling them before the end of the year will trigger capital losses. These losses are netted against capital gains in calculating the net capital gain income subject to tax.
Finally, if the rental of the property generated losses in prior years that were suspended by the passive activity loss rules, the sale of the property in a fully taxable transaction will trigger the recognition of those losses. You may have suspended losses if your income was over $150,000 ($75,000 if you were married filing a separate return) or the operating loss in any one year was over $25,000. Take a look at your 2012 income tax return and see if contains Form 8582 and related worksheets. They will show any suspended losses that may carry-over to 2013.