What is the Purpose of this Paper?
We get asked many times what will be the tax impact if I sell ? The purpose of this paper is to answer that question and help property owners decide what they should do.
With the many changes that took place in 2013, including capital gain tax rates, the NII and 3.8% Medicare tax, many investors and business individuals have multiple questions they need answered before they proceed with selling decisions.
While his paper does not purport to give legal or tax adviser advice, we hope it will help answer some of your questions before you contact your CPA or tax adviser for their professional answers.
In 2013 we developed a paper entitled “REC 2013 Tax Thresholds and Rates” to provide answers for the many questions we received. As you will see, based on your income, there are many taxes that will be imposed on any gain if you sell, along with recapture of depreciation taken or allowed.
SINCE A 1031 EXCHANGE WILL DEFER THE GAIN AND DEPRECIATION RECAPTURE OF AN INVESTMENT OR BUSINESS PROPERTY — IT IS A VIABLE ALTERNATIVE YOU SHOULD CONSIDER.
2014 Income Tax Rates
The marginal Tax Rates from 2013 have been increased by inflation for 2014 and published in IRS Revenue Procedure 2013-35. As a result, the income for most rates has gone up 1.6%. The rates for a Single filing status or if Married filing jointly are shown below and will be referred to often.
2014 – Marginal Income Tax Rates
| Tax Rate | Income if Single | Income if Married |
|---|---|---|
| 10% | up to $9,075 | up to $18,150 |
| 15% | up to $36,900 | up to $73,800 |
| 25% | up to $89,350 | up to $148,850 |
| 28% | up to $186,350 | up to $226,850 |
| 33% | up to $405,100 | up to $405,100 |
| 35% | up to $406,750 | up to $457,600 |
| 39.6% | $406,750 and over | $457,600 and over |
Capital Gain Tax
When you sell any capital asset, like a second home or apiece of heavy equipment, you will have to pay a capital gain tax. If the property was held over one year the long term rate applies.
The Long-Term Capital Gain Rates for 2014 are as follows:
| Tax Bracket | Rate |
|---|---|
| 10% - 15% | 0% |
| 25%-35% | 15% |
| 39.6% | 20% |
The 20% rate applies on that portion of net capital gain (line 13 of Form 1040) that puts taxable income (line 43, Form 1040) over the 39.6% thresholds, or $450,000 (MFJ). The Gain below the threshold is taxed at 15%.
To compute what your gain/profit tax rate will be if you sell a property (ex: second home or residential rental) use the following:
| Projected Selling Price | $_______________ |
| Less: Original Cost of Property | $_______________ |
| Less: Improvements | $_______________ |
| Less: Selling Expenses | $_______________ |
| Equals: Total GAIN (profit) on property | $_______________ |
| Tax on Gain at Capital Gain rate | $_______________ |
The total depreciation taken or allowed on second home/residential property (Section 1250) is recaptured and taxed separately at 25% as ‘Section 1250 gain’ (see below).
Depreciation Recapture
The term “Depreciation Recapture” is both descriptive and commonly used. While the IRS uses the term “Section 1250 Gain” to identify depreciation taken that must be recaptured when a Section 1250 property is sold. For Section 1250 property (most residential rental property) the tax is total depreciation taken times 25%.
So when you sell a property the total of all the depreciation taken will be recaptured and taxed at 25% regardless of your other income.
To record the depreciation to be taxed use “Unrecaptured Section 1250 Gain Worksheet-Line 19” in the Schedule D Instructions (page D-12). Place line 18 of the Worksheet back on Line 19 of the Schedule E. From there the amount will be posted on the “Schedule D Tax Worksheet” contained in the Schedule D instructions (page D-14) and finally included in the Tax on all taxable income on Line 43, Form 1040.
BECAUSE CAPITAL GAIN and SECTION 1250 GAIN HAVE DIFFERENT TAX RATES – DO NOT COMPUTE the TAX from LINE 43 and PUT ON LINE 44 — but FIGURE THE TAX ON the “SCHEDULE D TAX WORKSHEET” and then put it on LINE 44, FORM 1040.
3.8% Medicare Tax Rules
If the seller has increased adjusted gross income, including Capital Gain, over the threshold amounts, they may also have a 3.8% Medicare tax. The threshold amounts are $200,000 for singles, and $250,000 for marrieds filing jointly. The threshold amounts are not indexed for inflation.
If your adjusted gross income meets the threshold amount, then the 3.8% Medicare tax is the lesser of the tax on all your investment income (which includes rents, and capital gains) OR the 3.8% tax on adjusted gross income over the threshold.
Use Form 8960 ‘Net Investment Income Tax’ to compute this additional tax on Line 17 and add it at Line 60, Form 1040 to tax already owed.
Higher Tax Exposure if you Sell
The major concern is that a taxpayer whose tax rate has been the same for many years, will upon sale of a property, be suddenly and unexpectedly faced with a higher tax rate and other taxes.
For example: a married couple in the 25% rate bracket and with taxable income for years not over $148,500 sell a property in 2014 that has a taxable gain/profit of $300,000 suddenly find themselves in the 35% bracket, along with having to pay 25% depreciation recapture (called Section 1250 gain), and possibly be exposed to the additional 3.8% Medicare tax.
Personal Exemption and Itemized Deduction Limits
If your adjusted gross income (including capital gain) (AGI) is
$250,000(single) or $300,000 (joint return) or greater your personal exemption may be reduced and itemized deductions basically reduced by 3% of the amount which AGI exceeds the threshold.
Tax Penalty for Late Payment
When a property is sold and goes to settlement, the capital gain and depreciation recapture taxes are due. If an estimated tax payment, beyond normal withholdings, is not made the IRS may impose a tax penalty.
Income Levels and Thresholds
- The highest 39.6% marginal tax rate and 20% capital gain rate are in effect for $400,000 (single) and $450,000 (MFJ)
- Medicare 0.9% tax on income at least $200,000 single and $450,000 (MFJ)
- 8% Medicare Tax considered only if income of $200,000 for single and $250,000 (MFJ)
- Person Exemption and Itemized Deductions reductions start at $250,000 single and $300,000 (MFJ)
If a 1031 Exchange is done the tax is deferred.
Edwin V. Horan, 1031 Consultant, ed@1031.us