Understanding - And Deferring - Capital Gains
by Benny L. Kass

Q. We plan to sell some property which we have used as rental property for about ten years. I recognize that any depreciation I have accumulated over the years must be added back to arrive at the correct price, less any improvements subtracted out to figure the taxable gain. The purchaser is putting down about 25% and I will hold the remainder on a first note for 15 years. What options, if any, do I have on handling the capital gain? For example, must I treat my profit as a gain in the year I sell the property, or may I pay tax on the gain over a period of years?
A. There are several methods of dealing with capital gains, and they will be highlighted in this article.

First, however, let's get a basic understanding of how one computes capital gains. There are a number of important terms which are used in determining how much profit you have made — and thus how much money you will have to pay the IRS.

Basis: this is usually the cost of the property you have purchased. However, if you inherited the property, or received it by a gift, there are different rules. With a gift, the basis of the donor becomes the basis of the donee. In an inheritance situation, generally the basis will be the appraised value on the date of death of the person whose property you inherit.
Adjusted basis: this is your original cost plus any additions or improvements you have made to the property, minus certain deductions such as casualty losses or depreciation. You should go back to the settlement statement you received when you first purchased the property. Items such as settlement fees, transfer and recordation tax, title insurance and legal fees are all legitimate items to be added to basis.
Amount Realized: This is the amount of money you obtain when the property is sold. This is an area often misunderstood by sellers. If you sold a house for $400,000, on which there was a $200,000 mortgage, you will only receive $200,000 in cash from the settlement attorney. But in reality you have also received another $200,000 by having the mortgage paid off at closing, so the ìamount realized" in this example is $400,000.
Amount Recognized: this is the magic tax term for the gain or loss which you will make when the property is sold. If the property has been held for less than one year, it is a short-term gain; if the property has been held from more than one year, it is a capital gain.
Now, let's look at your situation. You purchased the property for $100,000, and have a sales contract now for $400,000. Over the past years, you have taken depreciation of $27,000, and have put in $50,000 worth of improvements. Your basis (or adjusted purchase price) is $123,000 ($100,000 minus $27,000 plus $50,000).

You are selling the property for $400,000 and will pay a commission of 6%, or $24,000. Your selling price is thus $376,000. Oversimplified, your capital gain is the difference between the adjusted selling price ($376,000) and the adjusted purchase price of $123,000 — namely $253,000.

For Federal Income tax purposes, you will have to pay the following taxes:

recapture: over the years, you have been deducting depreciation. Now, its "payback" time — also called a ìrecapture tax". Current tax law will require you to pay a 25 percent tax on the amount you have depreciated. In your example, since you have depreciated $27,000, the recapture tax will be $6,750.
capital gain: since you have held the property for more than one year, you are eligible for the capital gains tax rate, which currently is 20 percent of the appreciation.
Selling Price: $400,000
Less Commission: $24,000
Adjusted Sales Price: $376,000
Less Adjusted Basis: $123,000
Amount Realized: $253,000

Thus, the capital gains tax will be $50,600, Your total obligation to the IRS will be $57,350 (capital gains tax plus recapture). You will also have to pay state or local tax, based on the rate in the jurisdiction where your property is located. (Note: there are some special capital gains tax rates and rules for lower-income taxpayers, as well as for properties purchased after December 21, 2000. If you believe you fall into any of these special categories, you must consult your tax advisor.)

That's a lot of money to pay. Are there ways to defer — or even avoid — paying this tax?

The simplest way to defer this entire gain in its entirety is to just not sell it. The next best way is to enter into a like-kind exchange, pursuant to Section 1031 of the Federal Tax Code. Under these circumstances, if you engage in a trade, and obtain other real estate within 180 days from the time you sell your current property, and if you follow the IRS rules carefully, your gain will be deferred.

Let us assume that you obtain a replacement property for $400,000. The basis of that new property becomes the basis of the old property. While this will affect you when you sell that next property (unless of course you enter into yet another like-kind exchange) it will give you the opportunity to put all of your money into the replacement property, and not have to give it to Uncle Sam.

As I have indicated, the rules are rigid. The most important aspect of a like-kind exchange is that you cannot have access to one penny of your sales proceeds -- but rather they all go into the purchase of the new property. This column cannot go into the details of a like-kind exchange, but you should consider that option now before you finalize the sales transaction. Once you have completed the sale on your investment property, it will be too late.

A second method of deferring the capital gains is through the installment sale approach. Under this concept, since you are taking back financing, you will not be receiving all of the sales proceeds in the year of sale. According to the Internal Revenue Service, the amount of income that you have to pay from an installment sale in any one tax year, including the year of sale, is equal to the payments received on the sale during that year multiplied by the gross profit ratio for the sale.

The gross profit ratio is a complex formula which should be calculated by your tax and financial advisors. The bottom line, however, is that a portion of the monies that you receive each and every year on your seller take back financing relates to the gain that you have made, and it is this portion of the gain that is reported and taxed upon each year.

The interest income that you receive on the seller take back is, of course, taxed at ordinary income rates.

Despite statements from Congress — and politicians — that our tax laws should be simplified, over the years the law of real estate tax has become quite complex. While the concepts dealing with the installment sale are relatively simple, the mathematics are often mind-boggling, and you are strongly urged to consult your tax and financial advisors before you go to closing.