Q&A: Taxes on sold investment properties

How to figure out capital gain

Several years ago, we purchased a small ranch with a house in Texas. We paid approximately $175k. We are now divorced and want to sell the property, but we do not know how much capital gains taxes we will have to pay. We put almost $30k in improvements to the property which raised the appraised value to around $225k.

For capital gains, what matters is your actual sales price, not the appraised value. Let’s assume you sell your ranch for $210,000. You will have to pay closing fees, such as commissions to the Realtor, title insurance and such. Assuming a modest 7% for closing fees, it comes to roughly $15,000, leaving you with $195,000.

Now we need to figure out your “cost basis”, or investment in this property. Purchase price of $175,000 plus $30,000 in improvements = $205,000. We did not include the closing costs you paid at purchase, and possibly some other deductible costs. But even without these extra costs, you have a $10,000 capital loss rather than gain!

What if you’re able to sell for a better price, say $240,000? Using the same calculation, your capital gain would be $240,000 minus $15,000 closing costs minus $205,000 cost basis = $20,000. The long-term capital gains tax on it will be anywhere between zero and $3,000 (15%) and possibly a little higher, depending on your overall income last year, including jobs, businesses, investments etc. If your overall income was low enough, your capital gain taxes could be zero, even on $15,000 gain.

Finally, when talking about $3,000 tax, it is not worth complex tax planning. However, if you sell the ranch for much higher than $240,000 or your overall income is high, then please read my “Capital gains” article. It explains various ways to deal with real estate capital gain tax.

Deductible expenses when property is sold

Would you consider a home warranty and a foreclosure listing service costs as a deductible expense on the schedule E? I think that they are “ordinary and necessary,” but I wanted to get your opinion!

Yes and yes.

When are capital gain taxes due?

We will owe capital gains on property just sold. When will the capital gains tax be due?

The simple answer: This coming April 15th, when you file your tax return for this year.

But, like all simple answers, it may not be complete. First, there is a possible issue of the estimated tax payments. If, as a result of your capital gains, your tax return will show a total balance due to the IRS of more than $1,000, you may owe the IRS an “estimated tax” payment which is due January 15th. The rules about estimated tax payments are fairly complicated, and you can try to make sense of them using this section of the IRS website.

The good news is that, even if you’re supposed to make an estimated payment in January, missing it is a minor offense. In the worst case, the IRS will hit you with what they call an estimated tax penalty. It sounds scary, but in reality, it is nothing more than an interest calculated using Federal rates – currently 3% annual. Just make sure to not miss the April 15 deadline, to prevent more significant penalties.

Finally, you used the term “capital gains.” I want to caution you that this term only applies to sales of rental investment properties, as opposed to flip properties. If you sold a flip property, the timing of your tax payment does not change, but the tax itself will be much higher. Please see my article on selling investment property.

Taxes on inherited property

My father died last year. Left a will leaving his property 50/50 to me and my sister. Do I pay capital gains on my portion of the inheritance? Please explain why or why not.

No taxes on inherited property. Why? Because this is how our Congress wrote the law. You will only pay taxes if the property goes up in value from the day you inherited it to the day you sell it.

Ways to minimize taxes upon selling

If I purchase a property for rental purposes, what is the best way to minimize my taxes upon selling?
1. Create an LLC, place the property in it, and treat the real estate as a business?
    a. Would that be taxed at 35% if sold within the year?
    b. Would it be taxed at 15% if sold after one year?
2. Keep the property in my name and be taxed as above (35% if <1yr & 15% if >1yr)
3. What are the benefits of the LLC?
4. What is a ROTH IRA? Would that be tax minimizing?

• LLC does not change tax treatment of rental properties
• LLCs for rental properties do not have tax benefits; they are used mostly for legal protection
• rentals sold after 1 year are taxed at 15% on appreciation. In addition, there is a depreciation recapture tax – see this article.
• All IRAs, regular or Roth, do not pay current taxes – if the property was purchased with the IRA money. Roth IRAs and regular IRAs are taxed differently: Roth IRAs are taxed when money is put in, regular IRAs are taxed when money is taken out.