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Dear House Lawyer:
I am selling a house in Pennsylvania that I have rented out as an investment for the past 10 years. I want to take the money I make on this sale (paid $400,000, selling for $500,000, made no capital improvements and not paying any sales commissions or closing costs, so net cash profit should be about $100,000) and pay down my mortgage on my Maryland principal residence. What are the tax implications?
Dear: Smiling Seller:
Congratulations on successfully investing in a rental property. When you sell your rental property you will incur federal and state capital gains taxes. Capital gain is the difference between your selling price and your adjusted tax basis. The IRS classifies capital gains as either short or long-term. Gain on the sale of property held for one year or less is considered short term and is taxed at your ordinary income tax rate. Gain on sale of property held for more than one year is classified as a long-term capital gain and is taxed at rates ranging from 0% to 20%. Most homeowners will pay at the 15% rate.
Although you state that your net profit is $100,000, this $100,000 is solely your taxable long-term capital gain; according to Michael T. Berson, a Bethesda, Maryland, CPA, “assuming you are in the 15% capital gains tax bracket, your Federal capital gains tax liability would be $15,000. In addition, you have a depreciation recapture tax liability on $109,080 of your cumulative depreciation. Your Federal tax on the recapture of this depreciation is an additional $27,270. For a total Federal tax hit of $42,270.” You may also incur the new Net Investment Income Tax. That tax imposes an additional 3.8% tax on your net investment income above certain thresholds. (See, my prior column explaining this new tax in detail). Finally, “you will also be subject to state income taxes,” Berson added.
IRS regulations generally require that you depreciate residential rental property over 27.5 year life at an average of 3.636% per year. To calculate your depreciation deductions, we assume that your $400,000 purchase price was allocated between the land valued at $100,000 and the improvements valued at $300,000. You stated you made no other capital improvements. So, you were able to take an average of $10,908 annual depreciation expense deductions on your tax return (3.636% times $300,000) for each full year you rented it. This non-cash tax deduction reduced your taxes on an annual basis. But now that you are selling, this non-cash tax deduction must be paid back in part, as depreciation recapture tax.
Since land does not wear out, the IRS does not permit you to depreciate the purchase price attributable to the land. When you apply the 3.636% annually against your $300,000 depreciable basis for your 10 year holding period, you have taken $109,080 in accumulated depreciation deductions. That amount will now be “recaptured” and generally taxed at the 25% tax rate. So, in addition to your capital gains tax, you will incur the $27,270 in depreciation recapture tax.
Because this is investment property you are not eligible to use the $250,000/$500,000 capital gains exclusion available when you sell your primary residence. IRS publication 544 available online at www.irs.gov contains detailed instructions for calculating capital gains and depreciation recapture for residential rental property.
Prepaying your principal residence mortgage will save you interest over the life of the loan. Making a partial mortgage prepayment will not reduce your monthly payment however on a fixed rate mortgage. Assuming you have a fixed rate mortgage, your existing monthly payment amount will remain the same. Your principal prepayment just causes the mortgage to be paid off sooner. Before making a large prepayment you should contact your lender in writing: to notify it that you are making a prepayment and to confirm that there are no prepayment penalties. You should also consult a financial planner or CPA to evaluate if paying down your mortgage makes economic sense since with the partial prepayment, you will now have a smaller mortgage interest deduction.
Since your current plan to sell investment property and use the proceeds to reduce the mortgage on your principal residence results in significant tax liabilities with no real tax advantages, you may want instead consider using a 1031 like-kind exchange to sell your Pennsylvania property and invest your profits in another investment property near your Maryland residence.
A 1031 like-kind exchange requires you to identify your replacement property within 45 days, and to close on your replacement property, within 180 days after your Pennsylvania property settles. A 1031 like-kind exchange allows you to defer liability for all federal capital gains and depreciation recapture taxes. You can sell your Pennsylvania property and pay no federal income taxes on that gain so long as you use a qualified exchange intermediary to hold your funds and you reinvest your entire sales proceeds in a new investment property having a value equal to or greater than your Pennsylvania property. Please also note that Pennsylvania rules on 1031 exchanges are more restrictive then the federal rules.
Harvey S. Jacobs is a real estate lawyer with Jacobs & Associates ~ Attorneys At Law in Rockville, MD. He is an active real estate investor, developer, landlord, settlement attorney, lender and Realtor. This column is not legal advice and should not be acted upon without obtaining your own legal counsel. Contact Harvey at (301) 300-6252 Jacobs@Jacobs-Associates.com or Ask@thehouselawyer.com