Capital Gain Tax on Investment Property

The acquisition, ownership, operation, and disposition of Investment Property often results in generating a Capital Gain, and gives rise to a tax liability. For taxation purposes, Investment Property is categorized into two types of properties: Real Property, commercial or residential, and its components (classified as Section 1250), and Personal Property, tangible and intangible, which is subject to an allowance for depreciation/amortization (classified as Section 1245).

The length of time that the property was held for investment will have a significant impact on the tax rate of the Capital Gain. Capital Gain on investment property held for investment for a period of one year or less is considered a Short Term Capital Gain.  Capital Gain on property held for investment for a period of more than one year is considered a Long Term Capital Gain. While the Short Term Capital Gain rate is based on your personal income tax rate for the current return year, Long Term Capital Gains enjoys more favorable rates.  Presently between 15% and 35%, depending on your personal income bracket.

Capital Gain or Loss?

Capital Gains may significantly affect the amount of tax due on your tax return. However, with careful planning capital gains may be offset against capital losses realized during the same tax year, avoiding or significantly reducing a tax liability.

When the cost of ownership and maintenance, including depreciation/amortization, exceeds the income generated by the disposition of investment property, the result will be a Capital Loss. It is worth noting that Capital Loss deductions are limited to $3,000 per year. The unutilized balance can be carried over to subsequent returns indefinitely.

Depreciation Recapture

The IRS’s Depreciation Recapture provisions are defined as follows: “When you dispose of depreciable or amortizable investment property at a gain, all, or a portion of the gain may have to be treated as ordinary income”.

During the ownership period, the depreciation/amortization of the investment property generated tax savings at ordinary income tax rates. Therefore, upon the disposition of the investment property, the IRS will treat the total depreciation/amortization for the ownership period as ordinary income, and will tax that amount at your ordinary income tax rate.

Deferring Capital Gains

Section 1031 of the IRS enacts provisions to postpone or defer the Capital Gain tax liability arising as a result of the sale of investment property under a 1031 Exchange, providing that you re-invest the proceeds in like-kind property. Both properties must qualify as like-kind, property of the same class of nature. For instance, most real estate will be like-kind to other real estate. A vacant parcel of land could be like-kind to a property that is improved with a rental property. If the exchange includes other property not considered like-kind, such as cash or debt relief, it may be considered boot, and it will trigger a taxable event.

Individuals, C corporation, S corporations, partnerships, LLCs, trusts, and other taxpaying entities qualify for an exchange under Section 1031. Exchanges could be simultaneous, deferred, and reverse, and are generally done though a facilitator. Deferred and reverse exchanges are more complex, but allow some flexibility in the timing between the disposal and the acquisition of properties. However, the following time limitations apply: The first limit is 45 days from the date of the sale of the relinquished property to identify the potential replacement property. The second limit is that the exchange must be completed within a maximum of 180 days after the sale of the relinquished (exchanged) property. Tax deferred exchanges are an excellent vehicles for wealth preservation, but highly complex.

Getting Financial Help

Capital Gains and Losses are reported on Schedule D, derived from critical decisions and options, complex calculations, as well as skilled record keeping and knowledge of tax implications that may have a significant impact on tax liabilities on the present tax year, as well as on subsequent years, Therefore, It is critical to obtain expert Financial/CPA advice for properly tracking, managing, and reporting Capital Gains.