What Will I Net If I Sell?

1. Introduction

Given the reduction in the capital gains rate from 28% to 20% for long term capital gains, it is once again important for all of us to ask ourselves the following question: What will I net, after tax, if I sell my rental property this year?

The answer to that question is most often, Well, that depends. You see, your tax liability will be a function of many factors. Those factors that need to be considered in this analysis are the type of sale executed (outright sale, installment sale, 1031 exchange, etc.); other sources of taxable income and loss generated during the current year (i.e. capital gains/losses, rental income/losses, etc.); or any carryforward losses from prior years (net operating losses, passive activity losses, capital losses, etc.).

Even though we will have to consider many factors in getting to the bottom line answer, we always start the problem solving process the same way, by doing an Outright Sale Analysis.

2. Basic Data Gathering

Aside from asking which property are we doing the analysis on, we have to determine the projected date of sale, the selling price and the outstanding debt. The date of sale is important for determining cumulative depreciation and holding period. The selling price is used in the basic calculation as well as in projecting the cost of selling. The debt balance will be used to calculate the cash available at close of escrow.

3. Before Tax Calculation

With a projected sale price at hand we can estimate the expense of sale. The expense of sale consists of the various fees that you, as a seller, have either contracted for or are legally obligated to pay. They include but are not limited to broker's commission, escrow fees, lender fees, transfer fees and title fees.

Typically, the commission is the largest component of the expense of sale, ranging from 0% to 10% of the sale price. With no specific listing agreement to rely on, it is a common practice to use 6% as a projected commission rate on rental real estate. The escrow fees, lender fees, transfer fees and title fees can be approximated to total an additional 1%. Thus, as a rule of thumb, 7% is a good estimate of the expense of sale.

Illustration #1

Mark had just sold his apartment building in Los Angeles for $625,000. He paid both the selling agent and the listing agent $18,750 for a total of $37,500 or 6% of the sale price. In addition, he paid $1,800 in escrow fees to the escrow company; $1,465.92 in title fees to the title company; and $755.89 in transfer taxes to the city and county for a total of $4,021.81 or 0.64% of the sale price in miscellaneous fees. This equals a grand total of $41,521.81 or 6.64% of the sale price as the expense of sale.

Given a projected sale price and an estimate of the expense of sale, we can now calculate the Gross Proceeds figure. Simply stated, for tax purposes, the Gross Proceeds figure is the Sale Price less the Expense of Sale.

Illustration #2

Mark is planning to sell another apartment building in Los Angeles this year for $825,000. His projected Gross Proceeds from this sale would be calculated as follows:
Once we have projected the Gross Proceeds from the sale, we need to calculate the Cash at Close of escrow.

To do so we need to know the mortgage balance(s) on all outstanding debt at the time of close. This figure(s) can usually be looked up. A lender will typically invoice the borrower on a monthly basis. The lender's statement will usually show the balance based on the previous payment. Using the last principal balance figure and projecting out principal payment credits to the date of close will get us pretty close to the figure we are looking for.

(1) Sales Price	$825,000
(2) Expense of Sale (@ 7%)	$57,750
(3) Gross Proceeds (line 1 less line 2)	$767,250

Given an estimate for the Gross Proceeds and an estimate of the Outstanding Debt, we can now calculate the Cash at Close figure. Simply stated, on a before tax basis, the Cash at Close of escrow figure is the Gross Proceeds less the Outstanding Debt.

Illustration #3

Mark is planning on selling for $825,000. Mark's building is encumbered by two loans. A first whose projected balance at close is $525,000 and a second whose projected balance at close is $66,000. His projected Cash at Close would be calculated as follows:

(3) Gross Proceeds	$767,250
(4) Outstanding Debt	($525,000 + $66,000) $591,000
(5) Cash at Close (line 3 less line 4)	$176,250

4. After Tax Calculation

Your Taxable Gain in a sale can be looked at as the difference between what you gross from the sale and what your tax basis in the property is on the date of sale. What you gross from the sale is what we have been referring to in this article as the Gross Proceeds.

Your tax basis in a property depends a lot on how you initially acquired the property, what you did to the property and how you used it during your ownership period.

Property is usually acquired in one of two ways. You either purchase the property or you are gifted the property. If you had purchased the property initially for rental purposes and used it as a rental throughout your ownership period, then your initial tax basis was your purchase price. If over the years you improved the property, then your tax basis is increased by the cost of those improvements.

Those of us who own and operate rental property are familiar with the concept of depreciation. Depreciation is a tax deductible write-off that the government requires us to take throughout the period in time that we own and operate the property as a rental.

Residential rental property placed in service today is depreciable in a straight line fashion over a period of 27 ½ years. Between 1982 and 1986, we were permitted to depreciate in an accelerated fashion over periods as short as 15 years and as long as 19 years. Prior to 1981 we had various other methods available for depreciation.

The reason depreciation is important to understand in the Outright Sale Analysis, is due to the requirement that we recapture previously allowed depreciation when we calculate the taxable gain. In other words, depreciation reduces our tax basis in our calculation of gain and thus increases our taxable gain. More importantly, depreciation recaptured gain is taxed at a maximum rate of 25% (vs. 20% for long term gain).

The tax basis we use in our calculation of taxable gain is referred to as the Adjusted Basis. In our scenario described above, the Adjusted Basis is calculated by adding the purchase price and the cost of improvements made over the years of ownership and then subtracting from that total the depreciation allowed over the years of ownership.

Illustration #4

Mark's property was purchased in 1978 for $267,500. Over the 18 years that Mark has owned the property he has spent approximately $48,565 in improving the property. Over the same period of time, Mark was allowed to depreciate $143,872 of these costs for tax purposes. This year, prior to the close of escrow, Mark will be allowed to depreciate an additional $3,892. Mark would then calculate his adjusted basis as follows:

Adjusted Basis can be complicated to compute in circumstances other than the one described above. You see, if you acquired this property in a tax free exchange then your basis in the property would have a carryover component. Typically it is safe to say that your purchase basis in property acquired through a tax deferred exchange is its purchase price less the gain deferred on the sale of the previous holding(s).

(6) Purchase Price	$267,500
(7) Cost of Improvements	$48,565
(8) Depreciation Allowed	($143,872 + $3,892) $147,764
(9) Adjusted Basis (lines 6 and 7 less line 8)	$168,301

If the property was acquired by gift, then most likely the original cost basis would have been the property's adjusted basis in the hands of the donor at the time of the gift. If the property was acquired by inheritance, then most likely the original cost basis would have been the property's fair market value at the time of the donor's death. If the property was converted from personal use (example: your home), then the basis at the time of conversion to a rental would have been the lower of the cost or fair market value.

Please note that the cost of improvements identified above as an addition to the tax basis are expenditures other than those expensed in the year paid. We are not allowed to both deduct the expense on our tax return in the year paid and use it again in full in the year the property is disposed of.

Now that we know what the property's Adjusted Basis is at the projected date of sale and we have determined the anticipated Gross Proceeds, we are ready to subtract the former from the latter to arrive at the Taxable Gain.

Illustration #5

The Taxable Gain projected for Mark's property is calculated as follows:

(3) Gross Proceeds (line 1 less line 2)	$767,250
(9) Adjusted Basis (lines 6 and 7 less line 8)	$168,301
(10) Taxable Gain (line 3 less line 9)	$598,949

Now that we know what the property's Taxable Gain is at the projected date of sale we must differentiate the depreciation recapture component of the gain from the appreciation component of the gain. Our consideration here is that the new Federal law taxes depreciation recapture at a maximum 25% rate while the new Federal law taxes appreciation at a maximum 20% rate.

Illustration #6

The allocation of the Taxable Gain projected for Mark's property is calculated as follows:

(10) Taxable Gain (line 3 less line 9)	$598,949
(8) Depreciation	$147,764
(11) Appreciation (line 10 less line 8)	$451,185

It is important to remember that California does not have a capital gains preference rate and thus taxes capital gains just like ordinary income.

Illustration #7

Once we know what the projected Taxable Gain is, what the depreciation component of the gain is, and what the appreciation component of the gain is, then we can now calculate the State and Federal income taxes as follows:

(12) State Tax (@ 9.3% times line 10)	$55,702
(13) Federal Depreciation Tax @ 25%	$36,941
(14) Federal Appreciation Tax @ 20%	$90,237
(15) Total Tax (add lines 12, 13 and 14)	$182,880

Illustration #8

The Net, after tax, to Seller projected for Mark's property is then calculated as follows:

(5) Cash at Close (line 3 less line 4)	$176,250
(15) Total Tax (add lines 12, 13 and 14)	$182,880
(16) Net to Seller (line 5 less line 13)	$6,630

As you can see in the above illustration, the seller will owe more in taxes than the seller will receive at the close of escrow. You may ask yourself... How can that be? The answer is quite simple, the seller had borrowed the realized (but not recognized) profits tax free in previous years. After all how could someone have bought a property for $267,500 and owed $591,000?

5. Conclusion

With that much potentially going to the government, it behooves all of us to ask: Is there a better way?

From a pure after tax scenario it is important at this time to take the next step and look at the Net Taxable Gain Analysis. This latter analysis will consider the other sources of taxable income and loss generated during the current year (i.e. capital gains/losses, rental income/losses, etc.); as well as any carryforward losses from prior years (net operating losses, passive activity losses, capital losses, etc.).

RealTax professionals have the competence and experience to perform a Net Taxable Gain Analysis for your property and provide you with alternative strategies. We specialize in real estate oriented accounting, tax planning, tax preparation and related services. We invite you to contact us with regard to your specific needs.