Capital Gains on Home Sale - question

[Rollin]

I am considering selling my rental with a lease-option to purchase and am researching the tax implications around this. Does the "option" money (typically 3-5% of the home value, but can be higher) as part of the lease-option count towards the sale price? What I have been reading so far has not been clear, but it does appear as though the option is not part of the property sale, but rather the cost of obtaining an option to later purchase the home. It does not appear as though that is used as part of the down payment either.

This is all factoring into what I think my capital gains will be. On that note, I'm planning on FIREing 8/1/16, so taxable income next year will drop and my tax bracket will drop from 25% to 15% even without the sale. In addition, with the sale I'll loose rental income, further reducing my taxable income, and therefore increasing my ACA subsidy.

Lastly, I may use the proceeds from the sale, plus a little extra cash, to pay off my mortgage so I can eliminate 29 more years of mortgage payments (saving a lot in the long run - mortgage at 4%). I know I'm complicating this post, but it is on my mind so its coming out of the keyboard :). I know I could let the proceeds sit invested and come out close to the same as paying off the house, but investing is more risky than just paying off the home.

Any additional input is welcomed.

[arebelspy]

It depends on how your contract is written.

The most common way I've seen is there's a non-refundable option that is kept if the buyer backs out, but is applied as part of the down payment upon purchase if the L/O does complete.  In which case, it would be "part" of the sale price, because there would just be one sale price.

Make sense?

(Standard disclaimer about not trusting random info from the internet, consult a lawyer, etc.)

[Rollin]

Yes, that does make sense and seems more practical than keeping 3%+ for the option over and above the sale price. I do meet with a CPA tomorrow and I'll ask him the tax consequences surrounding this possible sale.

Thanks arebelspy

[Rollin]

Okay, and a big OUCH, but I'm looking at $27,000 in capitol gains if I were to sell this year (for $175,000) and $20,000 next after FIRE (due to lower taxes/income). I may do some more shifting of income by living off cash for the year as opposed to pulling from my 457K (tax deferred) and Vanguard  - both at 4% SWR. I think I can reduce my tax rate to the 10% bracket for the year, and therefore reduce the capital gains even further.

Any other suggestions?

[arebelspy]

Installment sale, to realize the gain over several years?

[bluecollarmusician]

What arebelspy said-
possibly even better, you could owner finance and receive interest back and spread out the capital gains.

[Rollin]

I researched capital gains last night and compared that to my now ex-CPA's input and the two don't jibe.  He said I would pay less next year when my income is lower, but I'll still be in the 15% bracket next year, albeit at a lower income. I know my income tax is really on a sliding scale (not a pure 15%), but he said with a reduction in income of $20,000 (from $73,250 to $53,250) the LTCG would drop from $27,000 to $20,000.  I'm trying to understand the formula so could any of you provide input?

Here are the numbers:

original purchase price - $70,604
depreciation - $50,454
possible sale price used in my discussion - $175,000

I calculate:

$50,454 x 25% = $12,614
$175,000-$70,604 = $104,396 x 13.74% (my affective tax rate) = $14,344
LTCG Tax = $26,958

Dropping my income by $20,000 next year to $53,250 only drops my tax rate to 13.27%, or the picture above resulting in a tax of $26,467.

My CPA said it would drop to about $20,000.

I know I should be asking him this question, but I'd like help first - and this is not the greatest time to ask non-tax submission questions of a CPA.

[Jim2001]

Rollin,

  You might also want to ask your next CPA about any liabilities on the depreciation recapture and how it fits into the equation. 

[Rollin]

Rollin,

  You might also want to ask your next CPA about any liabilities on the depreciation recapture and how it fits into the equation.

Thanks Jim2001.

I'll need to pass that past a new CPA because I just sent an email letting him know I wasn't happy with our last vista (he rushed me, was impatient, and upped his fee by 40% without advising me ahead of time). I know this is a tough time for people in the tax business, but I don't like the way it went down.

[Jim2001]

Rollin,

 Take a look at http://taxes.about.com/od/capitalgains/qt/recapture.htm and https://www.irs.gov/pub/irs-pdf/p544.pdf for more information on your recapture liability.  I found it interesting that the IRS will recapture some portion of the depreciation whether you claimed it or not. 

[Rollin]

I may be missing something important in my calculations and need some input. Below I have highlighted what I am inquiring about:

Here are the numbers:

original purchase price - $70,604
depreciation - $50,454
possible sale price used in my discussion - $175,000

I calculate:

$50,454 x 25% = $12,614
$175,000-$70,604 = $104,396 x 13.74% (my affective tax rate) = $14,344
LTCG Tax = $26,958

I have been reading that if I am in the 10% or 15% tax bracket that I pay 0% on that $104,396. Here is what I'm seeing (and reading in other locations):

The long-term holding period is more than one year. Long-term capital gains are taxed at long-term capital gains rates, which are usually less than ordinary tax rates. The long-term capital gains tax rate is either zero percent, 15%, or 20%, depending on your marginal tax bracket.

0% applies to long-term gains and dividend income if a person is in the 10% and 15% tax brackets,
15% applies to long-term gains and dividend income if a person is in the 25%, 28%, 33%, or 35% tax brackets, and
20% applies to long-term gains and dividend income if a person is in the 39.6% tax bracket.

So, do you all agree that my rate would be 0% (after paying 25% on the depreciation)?

[Vinivedivichi]

You should talk to a CPA that deals with this stuff.  I don't do personal taxes, so take this with a big grain of salt, but a few things you should consider/mention to your CPA:

1 - In your calculation, you don't appear to be including any repairs, etc. that are capital in nature to your original cost.  Did you ever replace the roof, paint, fix the flooring, replace the water heater/AC, etc?  Any of that would likely increase the basis (would just need to make sure you didn't expense it on your tax return, which you shouldn't have). 

2 - Your effective tax rate has nothing to do with the calculation at all.  In this part of your calculation "$175,000-$70,604 = $104,396", the 104k represents your long term capital gain (after the depreciation recapture).  See number 1 above, but assuming the 104k is a good number, that is the amount that is subject to your applicable long term capital gains tax rate (e.g. not your effective tax rate). 

3 - I think you are correct about a 0% long term CG rate if you are in the 15% bracket, but the only problem is that your gain would push you out of the 15% bracket (it's income).  This is an interesting situation - normally people (incorrectly) believe that making it to the next tax bracket means that all of your income is subject to that bracket's rate (e.g. many people think they can actually be worse off if a minor raise pushes them to the next tax bracket but that is not the case).  However, in this case, that line of thinking is appropriate since the 0% CG rate is black and white and ceases to be available if you surpass the 15% bracket.  Again, please discuss with a CPA because I am no expert in individual taxes.

If I were you, I would talk to a CPA about these items and see if there is a way to treat as an installment sale as someone mentioned.  If you are somehow able to recognize income over a few year period you may be able to get that 104k gain taxed at a 0% rate if you are able to remain at or below the 15% bracket. 

[Rollin]

You should talk to a CPA that deals with this stuff.  I don't do personal taxes, so take this with a big grain of salt, but a few things you should consider/mention to your CPA:

1 - In your calculation, you don't appear to be including any repairs, etc. that are capital in nature to your original cost.  Did you ever replace the roof, paint, fix the flooring, replace the water heater/AC, etc?  Any of that would likely increase the basis (would just need to make sure you didn't expense it on your tax return, which you shouldn't have). 

2 - Your effective tax rate has nothing to do with the calculation at all.  In this part of your calculation "$175,000-$70,604 = $104,396", the 104k represents your long term capital gain (after the depreciation recapture).  See number 1 above, but assuming the 104k is a good number, that is the amount that is subject to your applicable long term capital gains tax rate (e.g. not your effective tax rate). 

3 - I think you are correct about a 0% long term CG rate if you are in the 15% bracket, but the only problem is that your gain would push you out of the 15% bracket (it's income).  This is an interesting situation - normally people (incorrectly) believe that making it to the next tax bracket means that all of your income is subject to that bracket's rate (e.g. many people think they can actually be worse off if a minor raise pushes them to the next tax bracket but that is not the case).  However, in this case, that line of thinking is appropriate since the 0% CG rate is black and white and ceases to be available if you surpass the 15% bracket.  Again, please discuss with a CPA because I am no expert in individual taxes.

If I were you, I would talk to a CPA about these items and see if there is a way to treat as an installment sale as someone mentioned.  If you are somehow able to recognize income over a few year period you may be able to get that 104k gain taxed at a 0% rate if you are able to remain at or below the 15% bracket.

The great thing about this sale is the buyer and I have many options, so we can pursue it in a way that helps me with taxes and in return I can give a little better sale price.

Good information - thank you. I really do need professional help :)

[GuitarBrian]

Hi there,

I did the taxes for my parents when they sold their rental in 2014. Held for 30 years, 164k in gain.

First, it is not straight Schedule D LTCG. You have to file Form 4797. Your property will be Section 1250, or Section 1245 asset.

You will put the sale amount, and the depreciation... Then use a worksheet to figure your tax.

Basically, (These are rough amounts) a couple, filing jointly got up to 73k at 0%. To better explain... Say you make 20k in short term income (all normal income). You get 20k in standard deductions, so pay no income tax on this amount. You then get 53k in Long Term Capitol Gains, taxed at 0%.

If you make 50k in normal income, you would get 23k at the 0% rate.

Then the next part (up to 457k) is taxes at 15%. Any above this would be @ 20%.

Use the Schedule D Tax Worksheet, in the Schedule D instructions to figure it out.

First fill out form 4797. Then fill your regular income etc on your 1040. Then fill out Schedule D. Line 19, the unrecaptured section 1250 worksheet will put your depreciation into the mix. Then do the worksheet when requested on Line 20, check NO.


Don't forget to keep in mind. Most states don't care about long term vs regular income and they tax anything above your Standard deduction the same. Also states (my experience is with Colorado) will require you to pay estimates, or pay a fine.

edit: I read your other thread, and then posted here... not going to move it, but this info didn't really answer this thread's question.... I don't know the answer to the Lease Option tax implication.

[Rollin]

GuitarBrian

That makes sense (as much as anything can when does anything when it comes to taxes :). So, in other words not all the $104,396 gets hit at 15%, just that portion (combined with my normal income) above the 73K. The amounts below that are subject to the tax rates that combine to an "effective" rate (e.g., the first $9275 at 10%, the second up to $73K at 0%, and the remainder at 15%).

I'll do the sheets you suggested, as there is considerable depreciation in this too and I'd feel better putting it all together on the appropriate sheets/forms. I have someone who can do this for me, and then I'll likely consult with a CPA once I have it figured out (I like to do the best I can before consulting with a CPA).

Thanks.

Edit: I may work out a land contract with the buyer where I do this:

2016 - down payment
2017-2021 - installments
2022 - balloon payment

This should keep everything below the $73K cutoff, as in retirement my taxable income for 2017 is showing to be about $33K, with an AGI of less than $2K. Taxable increases to $47K for 2018 and stays at about that for a number of years (with AGI ranging from $18K and going up to $30K+ as the kiddies no longer are a deduction).

[Rollin]

I just had a question pop into the bean. In a land contract I (seller) hold the deed until payoff after balloon payment in five years. I'll have them pay me each month 1/12 of the insurance and taxes and I'll pay those myself. I wonder if I can still write those things off as if it were a rental? In fact I would like to set this up as if their payments are considered rent, but fully credited towards the sale price. That way if they default I can evict as opposed to go through foreclosure (I would write the contract this way).

Any thoughts on this?