Tax Tips Blog

Megan asks: I have rental property which I plan on selling. I’m estimating that I’ll have about $100K in profit. How will this affect me taxwise? I would also like to know if I should buy another property or use the money to pay down my mortgage. Any suggestions? Please respond. Thanks in advance, Megan

My response: Hello Megan, thanks for writing. I think it’s excellent that you’re asking these questions BEFORE you sell your rental.

The problem is that these are questions that you should be discussing with your tax professional, because without knowing a lot more information (your age, whether or not you manage the property, your financial situation now and expected in the future, the state you live in, etc.), I really can’t give you any specific advice and my general advice may not be appropriate for your situation.

If you’re like my average client, you’re probably mistaken on what your taxable profit in your rental is likely to be. Most taxpayers forget about adjustments to their basis and simply assume their selling price less what they initially paid for the property is their gain or loss. Not so.

You should ask your tax professional to estimate your estimated tax liability on the sale of your rental. If you’ve made any permanent improvements over the years since you purchased your rental property, these improvements will usually increase your basis.

The largest deduction to your basis is usually depreciation, whether or not you claimed it.

If you live in any of the disaster areas, you may have incurred a casualty loss that modified your basis.

Your property may be subject to depreciation recapture, which would change the character of profit that you will have.

How much tax you will pay on the gain will depend on your particular situation. You may find that this gain has caused you to be in a high tax bracket. Your exemptions and deductions may be phased out. You may be unable to make a deductible IRA contribution. This may even put you in an AMT situation.

The best thing to do is to sit down with your tax professional and have him or her help you plan this out. After your tax professional has helped you figure out your potential profit and related tax liability, then it is time to consider you options.

If you decide to purchase another rental property then the smartest tax method for this is called a 1031 exchange. You have to set this up BEFORE you sell your current rental, but once you do you can postpone paying tax on the gain from the sale. This is a complex transaction and should not be done with professional help.

If you decide to put your net profits into your home or into any other investment which would be considered personal in nature (stock market, savings account, etc.), you will need to make an estimated tax payment to the IRS and your state.

Best wishes,

Gina

Maria wonders:I purchased a new shed for my backyard. Should I be keeping the receipt for the shed, and when I sell my house I’ll add that to the basis and it will potentially reduces the tax I will owe on the profits of the house?

My response: Unless you live in California or Florida or some other area where houses are appreciating very nicely, you probably don’t have to worry about paying tax on the profit of your house.

Taxpayers are allowed to exclude (for Federal purposes) up to $250,000 in profit from the sale of their main home as long as they owned the home and lived in the home for a minimum of two of the last five years before they sold the home.  That said, it is always wise to keep track of your basis, because tax laws change, and when you do decide to sell it, who knows what the law will be.

If the shed is a permanent addition to your property, then it should add to your basis in your home. If it’s small and easily mobile, then it would probably be classified as personal property and would not increase the basis of your home. If you use the shed for any business or rental purposes (profit making purposes), you should depreciate it. As always, it’s best to ask your tax consultant.

Chad asks:I recently formed a LLC with my brother as equal partners. I contributed land worth $5,000 and my brother contributed $4,000 of cash and his old computer, which we agreed was worth the other $1,000 he needed to make us equal partners. Now our accountant is telling us that we aren’t equal partners, how can this be? My reply:I’m glad to hear you have an accountant because partnership taxation is a very complex area. This is something your accountant should have explained to you, when he or she told you that you weren’t “equal partners”. Since he or she didn’t automatically explain this to you; you should have felt comfortable enough to ask him or her right then. If you’re not comfortable talking to your advisor it may be time to find a new one. Now to your question. You most likely have a partnership agreement that says that you and your brother will be sharing equally in the capital and profits of your partnership and therefore you believe you are equal partners - and you are. However partnership taxation is anything but straight forward. Partnership taxation has what is called “inside basis” and “outside basis”. “Inside basis” refers to the partnership’s tax basis in its assets. “Outside basis” refers to the partners’ tax basis in their partnership interest. The land that you contributed may have been worth $5,000, but your basis in that land (close to what it cost you to buy it), prior to contributing it to the partnership, was probably much less. Whatever your basis was in the land that you contributed is now your basis in your partnership interest. Your brother contributed cash plus his computer. His basis in his partnershp interest will be the amount of cash he contributed $4,000 plus his basis in his computer (not what it was worth to the partnership, which you said was $1,000, but generally his original cost, which was probably higher). As I said previously stated, partnership taxation is a very complex area and I have simplified the rules to give you my best guess as to why your basis in your partnership interests are different even though you both contributed the same value to the partnership and intend on being equal partners in the profits. Best of luck with your partnership, Gina