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How to Avoid a Tax Hit When Selling Your Rental Property

Chat with Michael Eric Scott, CPA

Michael Eric Scott is a CPA, teacher, and author of U.S. Tax and SAP. He also runs the Targeted Tax Training School and the Video CPA YouTube Chanel.

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The Video CPA YouTube Chanel with Michael Eric Scott

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Show Notes:

Jana Christo

Hello, real estate investors. I’m Jana Christo, and I’m the publisher of Rentce, an online real estate resource for real estate investors and landlords. 

Today’s topic is how to prevent the tax hit when you sell your rental property. And I’ve invited  Michael Eric Scott,  a CPA with over 40 years of experience to help us navigate this topic. 

Michae has a master’s degree in accounting, he has worked for firms such as PricewaterhouseCoopers, and IBM. And he has also run his own accounting practice for 17 years. He is the author of the book US tax and SAP. I hope I’m pronouncing that correctly. He has taught accounting at the University of Texas at Arlington, and  Navarro College. Michael also runs The video CPA YouTube channel and is the force behind  The Video CPAs Targeted Tax Training  School.

 Michael, I’m tired from just reading all of this. How do you have the time to do all this?

Michael Eric Scott  1:38  

Well, you know, I am still working a little bit. But for the most part, I’m retired and so I do the I keep very active, but I do the two YouTube channels and then I’ve got the school. But on the other hand, you know, I, I do a lot of active activities like pickleball and bowling and, you know, anything I want to so I just keep myself busy.

Jana Christo  2:08  

Well, that’s, that’s a secret right there. So I’m really glad you found the time to help me out. 

I watched some of your videos on the subject, especially the depreciation recapture and I’m really excited to actually learn from you. 

And let’s start with a simple question. Okay. If I’m a real estate investor, and I’m selling my rental properties, what kind of taxes should I expect? And you mentioned that I should ask about basis. 

And just to give you some background on me, when I studied accounting in a Catholic school. And I’m still afraid of the nuns who taught it. I actually dropped the class. So explain it to me very simply, so I can understand. 

Also, the reason I picked this topic is a lot of investors are selling their rentals and they’re finding that some of the taxes like depreciation, they didn’t expect to pay that because they didn’t deduct it during the time they owned the property. 

Okay, so that’s why, you know, my first question is what exactly an investor would expect to pay?

Determining Your Property’s Tax Basis

Michael Eric Scott  4:11  

Well, there are two types of taxes. Now in Florida, I don’t think you have a state income tax to you, but I can’t remember but certainly a federal income tax and possibly a state income tax on the sale of a rental property. 

The problem is, I mean if you the way the IRS wrote the law is that it’s depreciable. It’s depreciated or depreciable. 

Okay, so if you’ve failed to take depreciation during the time that you’ve had that rental property, the IRS doesn’t care. They would just assume you go back and amend all your returns to take that depreciation or use some other method to take that depreciation at some point in time on the return. 

Jana Christo  5:03  

I’m sorry, I don’t want to interrupt you. But you can amend going back, how many years?

Michael Eric Scott  5:11  

Well, you can amend. Certainly, if you’ve got a commercial property that’s on a 39-year-old basis, you can’t amend 39 years, you can amend generally, back three years at least, and possibly four, depending on when the return was filed. But so if you haven’t taken depreciation, the IRS doesn’t care. Usually, I mean, they, they say it’s either depreciated or it’s depreciable. 

And you should have taken the depreciation. 

So that does I mean, that does hook a lot of people. Even if they’ve taken depreciation, and they know they’ve taken depreciation. Sometimes individuals don’t know that depreciation is recaptured on sale. And so when you sell a property, the depreciation that you’ve taken on that property is actually calculated as part of the gain on the sale

So with that in mind, let me talk about basis just a little bit. So basis is actually the costs that you’ve got in the building, okay. 

So your basis, if you buy a piece of rental property, you’re going to have and say you pay $210,000 for the $210,000 becomes your basis in the property. Now, that’s not necessarily the depreciable basis, because you have to subtract the land value out of that. And most times, when you buy property, they don’t tell you what that land value is. So you’ve got to estimate what the land value is. 

So when you’re doing depreciation, you’ve got the cost to pay for the property minus the land, and that would give you your basis for depreciation, but then you have to add in any purchasing expenses that you’ve acquired when you buy that property. And that’s not taxes and interest, because those things can be written off, and you may pay those things at closing. But those taxes and interest can be written off on an annual or annual basis. It’s things like, you know, all the closing costs that they stick you with, for different types of recording fees, that type of thing. 

And so if you look at your head one statement, pretty much most of the stuff on there would, would be written off as that basis, and I’ve got a YouTube video out there actually on how calculating your basis but so so as you go along, then that basis, then is deducted by the amount of depreciation you take. 

So, if you buy it for $210,000, and you’ve taken, say, $20,000 worth of depreciation, your basis on that property, is 190,000. Now, because it reduces the costs in there. So when you sell it, then you’re looking at a profit in that case of $20,000. Just on depreciation, you know. If the building appreciates in value, well, then you’ve got an additional profit there. 

Is depreciation recapture always 25%?

But so the depreciation was recovered at a maximum rate of 25%. So generally, it’s recovered at ordinary income rates or a maximum of 25%. And that is called Unrecaptured Section 1250 Gain. All right, okay, so if you make money on a property, the depreciation recapture is on recaptured section 1250 gain, all right. 

Any other gain that’s above that depreciation recapture then would be at ordinary income rates, and most people don’t understand that. So they think they’re getting capital gain treatment on the whole thing. And you know, essentially they’re not because they are the capital gain rate, the maximum capital gain rate is 25%. If you’re in a lower rate than that, you get the ordinary income rate and depreciation recapture. But on the rest of the gain, you get you do get your capital gain rates.

Jana Christo 9:32  

Okay. That’s clear to me.

 I don’t know if you understand that or not.

I do mostly because I read about and I watched your video. So just the question if somebody did not take depreciation. It’s They are lost in this. Like, they should have that.

Michael Eric Scott 10:04  

Yeah, there is. Yeah, I mean, they should have right. But there is an allowance, I think, and I haven’t done this for a while that you can take some of that depreciation when your sell, but

okay. 

Jana Christo

So it’s not the total loss. not totally. Okay. If somebody doesn’t want to pay those taxes, what are the options?

Michael Erick Scott 10:43  

They don’t want to pay their capital gains taxes on the gain. The option is to pay big penalties and go to jail. IRS doesn’t want to put anybody in jail but something a little bit. Don’t pay them, they’re gonna get a lien against all the other properties on them. 

Jana Christo 11:06  

So, can they exchange it for another property? 

Like-kind Exchanges under 1031

Michael Eric Scott  11:10  

Yes, they could exchange it for a like-kind of property. And most of the like-kind exchanges have been done away with except in the real estate area. It used to be, you know, that you trade in a car and you can, you can do a like-kind of exchange on an automobile and you just trade it in and get another one and the gain or loss, that’s all gone. But on real estate, you can, you can still do that. So there is an opportunity, if they would just assume to a like-kind exchange, they can delay any tax on the sale on the property by doing a like-kind exchange.

Jana Christo 11:48  

If you are selling let’s say, a couple of single-family homes, can you exchange them for a multifamily property? Would that be a like-kind exchange?

Michael Eric Scott 12:01  

As long as it’s real estate for real estate. You’re in pretty good shape.

Jana Christo  12:05  

One more question. When investors find how much money they have to pay in taxes, they look for the other options, and, of course, 1031 exchanges. But also, I’ve heard and I’ve read some discussions about seller financing. How would that be treated?

Installment Sale Tax Treatment

Michael Eric Scott 12:43  

Yeah, I mean, that would be, that would be an installment sale, and that would spread out the taxes on it. The only problem is, as you do an installment sale, you’ve got to have a pretty good buyer. Because sometimes you have to take that property back because you don’t get your payments. Installment sale does work. I mean, what it does, if you take a note for 20 years, it will prorate the gain over a 20 year period so that you don’t pay that tax is all upfront. So that is another way to do it.

Jana Christo  13:18  

Okay, what if you sell the note?

Michael Eric Scott 13:25  

Yeah, selling the notes not gonna make any difference? I mean, if you Oh, okay, I see what you’re saying. Yeah, if you take the note through an installment sale, and then you turn around and you collect some payments on it, and then sell the note, unfortunately, the sale of that note, generally, you’re going to sell it as a lot at a loss because it’s discounted, yes, but there’s still going to be some taxes on it, it’s gonna you’re going to have to calculate the loss on the sale of that note, and then compare that to the gain on you know, calculate the difference. Yeah,

Jana Christo  14:03  

That doesn’t sound like a good idea. So so those are the two options 1031 Exchange and the installment sale if you have a good buyer. Of course with the installment sale, you’re not gonna get the cash immediately as you would when you sell the property. 

That’s clear. I mean, those are really the questions that they had for you. Yeah, that’s pretty much what I have. In we talked about basis and I think you explained everything pretty well, now, if somebody wants to learn more about this where they should find you?

Michael Eric Scott  15:13  

Yeah, well, there’s, I think I have nine courses on real estate on our nine videos on real estate on YouTube channel. Okay, if they, if they need more, well then they’d have to go to my Targeted Tax Training Site. And that those are actual courses, though. I mean, they’re longer than the videos and in more detail than the YouTube videos. They actually incorporate the YouTube videos in them, but they’ve got a lot of text in them and quizzes and stuff like that. 

Jana Christo  15:51  

Okay, I will include this in the description of the video, and I will also transcribe the conversation so people can read it as a blog post, and I’ll just link to all of that. Because personally, I don’t watch a lot of videos I’d much prefer to read. So but we’ll have it in video form and as a blog post. Can I call you again if I have another question? 

Oh, sure, Jana, that’d be fine. 

Okay, great. Well, thank you so much, Michael. Appreciate it. Okay. Bye. Thanks. Bye.

Where

About the author

Jana Christo is a business owner, real estate investor, and property manager. She has 16 years of experience in most areas of real estate.
During the last recession, she was also the managing partner for a company that bought and rehabbed properties from the court foreclosure auctions. Today, she manages her own portfolio of rental properties and shares her experience on Rentce.com.