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The 4 Layers of Investment Real Estate Tax

When an investor sells investment real estate, they face not just a single layer of taxation but several layers. That’s why Section 1031 is such a potent weapon. In total, taxpayers face up to four distinct layers of investment real estate tax.  They come into play when taxpayer’s                            dispose of real property held for investment purposes.  They include depreciation recapture tax, capital gains tax, state level income tax, and the medicare surtax.  This latter is also referred to as the net investment income tax. Collectively, these different taxes can add up to produce exceedingly large tax liabilities. So it’s not uncommon for taxpayers to want to defer liabilities of hundreds of thousands of dollars.  That is done by way of a 1031 exchange.  

Each investment real estate tax has its own calculation methodology. In this post, we will discuss various thresholds and calculation methodologies.  We’ll look at these different taxes so that readers can get a sense of how these investment real estate taxes operate. As we will see, crunching the numbers for these taxes can be a bit involved.  As a result, it can be helpful to understand their respective underlying structures as best as possible. Our purpose here is twofold.  The firs is to shed light on these calculation methodologies.  Secondly, our readers may also come away with an enhanced appreciation for the power of Section 1031.                                                                                                                                

Depreciation Recapture Taxes 

When someone purchases an investment or business property, the property is considered to have a “useful life”.  That means that its value depreciates over time. The concept of depreciation is easily graspable.  When a property is an “investment” to a person, the basis of the property is reduced by the value it loses over time. Depreciation deductions allow investors to balance out the gradual loss in the value of their property.  It does so by reducing their current tax liability.  These deductions are netted against the basis in the property.  This then adjusts the gain which eventually results from a sale. 

Currently, the tax rate for depreciation recapture is 25%. Depreciation recapture is taxed separately from capital gain. Suppose an investor buys a new rental property for $500,000. This rental property would have a useful life of 27.5 years.  That means that its whole value, and the entire original basis, would be eliminated after that period of time.

Let’s suppose that our investor owns the property for five years and takes $91,000 in depreciation deductions. $500,000 divided by 27.5 equals $18,182, and $18,182 multiplied by 5 equals roughly $90,900, and then round up to $91,000). Assuming no capital improvements to the property, his or her adjusted basis after five years would be $409,000. Let’s further suppose that the investor sells the property for $750,000. In this scenario, our taxpayer would have to pay taxes on the depreciation recapture amounting to $91,000. The taxpayer then will also face additional taxation on the capital gains. In this example, the depreciation recapture liability would be approximately $22,750. 

Capital Gains Taxes 

Let’s continue to use the above scenario as we examine the other layers of investment real estate tax. As we mentioned, along with the depreciation recapture, our investor would also incur a liability for the capital gains derived from the sale. To determine our taxpayer’s capital gains tax liability, we need to start our computation with the gross sales price.  From that , we need to  subtract certain allowable closing costs and the original basis in the property.  The appropriate tax rate is then applied in order to determine the amount of tax owed. For the sake of simplicity we will ignore closing costs, however.

We will also limit our discussion to long-term capital gains for individual taxpayers. The current applicable thresholds and rates for long-term capital gains are as follows: for individuals in the 10% or 12% ordinary income brackets, the tax rate is 0%; for those in the 22%, 24%, 32% or 35% brackets, the applicable tax rate is 15%; and for those in the highest bracket – the 37% bracket – the rate is 20%. This means that the threshold for the 15% rate kicks in at an income level above $38,700, and the threshold for the 20% rate kicks in at an income level above $500,000.  

Let’s assume that our taxpayer in this hypothetical scenario earns an annual salary of $75,000. Our taxpayer had an original basis in the property of $500,000, and sold the property for $750,000; therefore, our taxpayer’s realized capital gain would be $250,000. Based on the figures, our taxpayer would face a long-term capital gains rate of 15% and the capital gains tax liability would be $37,500 (i.e., $250,000 multiplied by 15% equals $37,500). 

State Income Tax & the Medicare Surtax 

Our taxpayer would also face state level income taxes as well as the medicare surtax from the sale of his investment property. The state level income tax owed from the sale would depend on the particular state our taxpayer is located; state income tax rates range from 0% all the way up to 13.3%. Because depreciation deductions are considered a form of gain, our taxpayer will face a state income tax liability on the gain associated with these deductions in addition to the capital gain from the sale. Let’s assume that the taxpayer faces a 10% state income tax rate. Thus, the total state income tax liability would be $34,100 (i.e., $341,000 multiplied by 10%), and the full gain subject to state level taxation equals the full $341,000 (as opposed to just $250,000).  

As we discussed earlier in our feature article on the medicare surtax, our taxpayer will also face an additional 3.8% tax on the lesser of his net investment income or the excess of his modified adjusted gross income over his applicable threshold. In this scenario, our taxpayer’s net investment income would be $250,000, because depreciation recapture does not count toward net investment income for the purposes of calculating the medicare surtax liability. The threshold for our taxpayer as an individual filer is $200,000. Our taxpayer’s modified adjusted gross income, assuming that his MAGI is not affected by any deductions or exclusions, would be $325,000, that is, the sum of $75,000 plus $250,000. After reducing his MAGI by the applicable threshold of $200,000, our taxpayer would therefore pay an additional tax of $4,750 as a medicare surcharge on $125,000, because $125,000 is less than $250,000. 

Investment Real Estate Tax Help

As you can tell, investors can quickly face extremely large tax bills when they sell their investment property in a straight sale due to all of these different layers of investment real estate tax. The calculation methodologies for each of the investment real estate tax layers can be complex, particularly to those without a background in tax or finance. But this is exactly why the attorneys at Mackay, Caswell & Callahan, P.C. work hard to master this difficult material: we master it so that we can give our clients the best possible counsel. If you’re getting ready to sell real estate and are concerned about the liability you may incur, reach out to our NYC tax attorney and we will be sure to provide you with expert assistance in a timely fashion. 

Image credit: John-Morgan