An individual is planning on selling their rental home that they have kept as an investment for ten years. They paid $400,000 on the property and have sold it for $500,000. They have also made no capital improvements upon it and are not paying for closing costs or sales commissions. They would then like to pay the $100,000 net profit towards their principal residence.
Such a transaction will incur capital gains tax treatment by both the state and federal government. While capital gains would be the difference between the selling price and adjusted tax basis, such a formula is not as simple as it seems. It also does not take into account other forms of taxation that may result due to such a transaction.
Though the net profit is said to be $100,000, the long-term capital gains upon this property for tax purposes would be $209,080. For an individual in the 15 percent tax bracket this could mean a federal tax liability of $31,362. The reason why the taxable amount has been adjusted to $209,080 is because we need to take into account accumulated depreciation.
The IRS has a number of regulations concerning depreciation of rental property. These rules require a taxpayer to depreciate rental property over a defined period of time while at the same time allowing for an annual depreciation expense deduction. However, the non-cash tax deduction taken on a yearly basis must be recaptured in part when the property is sold.
Please keep in mind that this is only a partial explanation of everything that will need to be taken into account concerning tax issues involving such a sale. Put simply, tax compliance can be a nightmare for individuals trying to figure this out on their own. Without having an experienced attorney provide advice, it's likely the taxpayer will make mistakes on federal and/or state returns. This in turn could be costly.
Source: The Washington Post, "Reader’s plan to sell investment property has major tax implications," Harvey S. Jacobs, April 10, 2014