By Ivette Carrasco, CPA, Tax Manager
ASL Real Estate Group
There are different tax treatments to consider when selling your real estate property. The property can be classified as a primary residence, a real estate rental, an investment property, or a second home/vacation rental. The applicable tax consequences on the sale of a property depends on how the asset was classified in the current and prior tax years. It is important for real estate owners to be aware of the various tax implications that a real estate sale can trigger.
Selling Your Primary Residence
Generally, you can exclude a portion or all of the gain on the sale of your primary residence if you meet both the ownership test and the use test under Section 121 of the Internal Revenue Code (IRC). In order to qualify, you need to live at and own your primary residence during two of the last five years. The gain exclusion can be up to $250,000 for single taxpayers, and $500,000 for married filing jointly.
There are a couple of points that are important to consider if you are thinking about using this exclusion. First, this exclusion is not available to taxpayers who have already excluded a gain from the sale of their prior home within the two years prior to the sale of the primary residence. Second, there is an automatic disqualification if the home for which you are planning to use the exclusion for was acquired in the last five years in a like-kind exchange.
There are other partial gain exclusions for which you can still qualify, even if you did not meet the ownership and use tests. Partial gain exclusion can be claimed for sales caused by a work-related move, health-related issues, or other unforeseeable events.
If your home was previously a rental, you may not qualify for the full exclusion.
Selling a Rental Property
There are two subcategories when it comes to holding rental properties. Generally, a real estate rental is considered a passive activity. However, it may qualify as a trade or business.
Operating losses from a rental property treated as a passive activity are limited to offsetting other passive income. Some taxpayers are able to deduct up to $25,000 of their losses in the current year; however, there are some income limitations. Excess losses that cannot be deducted in the current year can be carried forward. If the passive activity is sold and the taxpayer is carrying suspended losses related to the rental, the losses are freed up in the year of sale and any amounts in excess of the gain can be used to offset other ordinary income (such as wages and investment income).
Gains from the sale of a passive activity are taxed at the long-term capital gain rate, assuming the property was held for more than one year. However, if the property is sold at a loss, it is treated as an ordinary loss, not a capital loss. This loss can be used to offset ordinary income and is classified as an IRC Section 1231 loss.
Rental property that is considered a trade or business in the hands of a taxpayer would generally be reported as an IRC Section 1231 gain or loss when sold. Gains on sale of this type of property are generally taxed at the long-term capital gain rate. Losses on this type of property can be treated as ordinary losses.
Care should be taken when considering the use of 1231 losses because there is a recapture provision. These losses are tracked and if a 1231 gain is recognized in any of the 5 years subsequent to the 1231 loss year, a portion of the 1231 gain may actually be taxed as ordinary income.
It is also important to consider depreciation taken when considering sale of real estate. This is because gain on a sale of rental real estate, to the extent of depreciation taken, is generally taxed at a 25% tax rate, rather than the long-term capital gain rate of 20%. This is called “depreciation recapture”. Depreciation recapture applies to both passive activity rentals and rentals classified as a trade or business.
If you are selling a rental property, you might want to consider doing a like-kind exchange (see Like-Kind Exchanges After 2017 Tax Cuts and Jobs Act for additional information). The Biden administration has proposed a change to the tax treatment of like-kind exchanges. The current proposal would allow the annual deferral of gain for up to $500,000 for single taxpayers ($1 million for married filing jointly). Any gains in excess to these amounts would be taxed in the year of the exchange.
Selling Other Types of Real Property
You can also hold real estate either as an investment property or as a second home or vacation home. Different tax rules apply to the sale of these types of properties.
When purchasing investment property, elections can be made that will minimize the gain on sale or in the case of loss, increase the loss.
A vacation rental is property that is personally used by the owners for more than the greater of, 14 days or 10% of the total days it is rented during the year. When selling a second home or a vacation rental the gain would generally be taxed as capital gains. If the home is sold at a loss, the loss may be limited or not allowed.
Additional Taxes to Consider
Two additional taxes that may also apply when selling real estate include state income taxes as well as the federal Net Investment Income Tax (NIIT). Depending on your individual tax situation as well as the location of the real estate sold, there may be state income taxes due upon the sale of your real estate. Additionally, if your adjusted gross income exceeds more than $200,000 (single filers) or $250,000 (joint filers), the gain on your sale of real estate will generally be subject to the NIIT of 3.8%. If the real property sold is considered part of an active trade or business, the NIIT may not apply, depending on how you classified the property during its ownership.
Future Uncertainty
While the information in this article is relevant today (July 22, 2021), the Biden administration has proposed changes to the current laws. We will continue to monitor new information as it becomes available.
Contact Us
Real estate sales can be complex. If you would like to discuss your unique situation, please contact our Real Estate Group or call us at 408-377-8700. We look forward to hearing from you!