Debits & Credits

by Doug Schultz & Paul Fong

Q. On December 31, 2006, I sold an apartment building that I owned for many years. My original cost basis in the building was $750,000, and I have taken line depreciation deductions of $250,000, leaving an adjusted basis of $500,000. My basis in the land is $250,000. The sales price of the property was $1,250,000, of which $900,000 was allocable to the building and $350,000 to the land. I have $100,000 of unrecaptured loss carryovers from the sale of another rental property three years ago. How do I calculate my federal tax liability?

A. Your gain on the sale of the building is $400,000 ($900,000 sales price less $500,000 basis). The $400,000 gain attributable to the building is taxed as follows: (a) $250,000, or the amount of depreciation claimed is taxed at a maximum rate of 25%, and (b) the remaining $150,000 of gain is considered the sale of property used in a trade or business and is eligible for the 15% maximum long-term capital gain rate. However, since you have had loss carryovers from the sale of rental property within the five preceding years, $100,000 of the gain will be taxed at your marginal ordinary income tax rate (which can be as high as 34%). The gain attributable to the land is $100,000 ($350,000 sales price, less $250,000 of basis), all of which is eligible for the 15% maximum long-term capital gain rate.

Q. On January 1, 2005, I bought a three-unit building for $1,500,000. On July 31, 2005, I sold the building and rolled $1,600,000 of the proceeds into a like-kind exchange for a six-unit apartment building that cost $2,100,000. As a result, I had to take out an additional $500,000 loan. In 2006, I decided to get out of the rental business altogether and sold the six-unit building for $2,500,000. The sale closed on June 1, 2006. Ignoring depreciation recapture rules, what is my gain on the sale in 2006 and how is it taxed?

A. Your basis in the property sold is $2,000,000 ($1,500,000 of original cost basis plus $500,000 of loan to acquire the replacement property). As a result, your gain is $500,000 ($2,500,000 sales prices less $2,000,000 of basis). Since the replacement property was not held for more than a year, a portion of the gain will not be eligible for long-term capital gain treatment. The proceeds will need to be allocated between the original purchase price of the property acquired in January 2005 (which is eligible for long-term capital gain treatment) and the additional loan proceeds used to acquire the replacement property in July 2005 (which is subject to short-term capital gain treatment). Short-term capital gain is taxed at your marginal ordinary income tax rate (up to 34%). As a result, $125,000 of the gain will be taxed as short-term capital gains ($500,000 of additional replacement basis divided by $2,000,000 of total basis multiplied by the $500,000 of gain) and the $375,000 balance will be taxed as long-term capital gain.

Q. I bought a rental property several years ago that has generated tax losses of $75,000 since inception that I have not been able to use because of passive loss rules. The property has appreciated $200,000 since I acquired it. In addition, I have $100,000 in unused capital-loss carryovers that occurred from a bad stock investment several years ago. I’ve been hearing a lot about like-kind exchanges. What are the tax ramifications of doing a like-kind exchange versus a straight sale?

A. In the like-kind exchange scenario, the $200,000 gain is deferred and not subject to current taxation. Your basis in the new property will be reduced by the amount of deferred gain, assuming no boot is distributed to you on the exchange. The passive losses of $100,000 will also carry over into the new property and will not be recognized as a current-year deduction. As a result, there is no current-year tax effect resulting from the exchange.

The tax consequences of a straight sale will result in the $200,000 gain being taxed in the current year. However, this will be offset by the $100,000 capital loss carryover. The net $100,000 gain will be taxed at the 15% tax rate (assuming there is no IRC-Section 1250 or ordinary income recapture for depreciation previously taken), resulting in a $15,000 tax. The nature of this gain is considered passive. As a result, you will be able to offset the $75,000 of passive losses that have been suspended in past years. Assuming your marginal tax bracket is 34%, you will also receive a tax benefit on the disposition of $25,500. Your net tax benefit for selling the property is $10,500 ($25,500 tax benefit offset by $15,000 tax due because of sale). In addition, your basis in any property acquired subsequently will not need to be reduced by the deferred gain, resulting in more depreciation and less tax on disposition in the future. Therefore, in your case a straight sale is more advantageous than a like-kind exchange.

Q. I have an in-law apartment in my house that I have been renting for the past few years. Since I am married, I understand I am eligible to exclude $500,000 of gain from the sale of my principal residence. Is the gain related to the in-law unit eligible for this exclusion?

A. Frequently, a portion of a residence is used for business purposes. When determining the gain exclusion, no gain allocation between business and nonbusiness use is required as long as both the residential and nonresidential portions are within the same dwelling unit. In other words, the entire property can qualify for the gain exclusion. However, the gain exclusion rules do not apply to that portion of a residence previously used for business or rental purposes to the extent of depreciation allowable for periods after May 6, 1997. Even if depreciation is not claimed, the adjusted tax basis of the property must still be reduced by the allowable depreciation. Foregoing depreciation deductions does not prevent the recognition of gain for allowable depreciation attributable to periods after May 6, 1997. The rule for recognizing gain to the extent of depreciation claimed after May 6, 1997, applies even if the property is no longer used for rental purposes at the time of sale.

Therefore, you can exclude up to $500,000 of gain except for the portion of gain that is attributable to depreciation deductions after May 6, 1997. The gain on the depreciation is taxed at 25% for federal tax purposes.

Q. In 1999, I purchased a home that was used as a personal residence until December 31, 2003. At that time, I acquired a new residence and converted my former residence to a rental property. I still reside in the new residence. On November 1, 2005, I sold the rental house, recognizing a $50,000 gain. At the time of sale, I had claimed depreciation deductions totaling $20,000, which all pertained to the period after May 6, 1997. Can I exclude the gain on my former rental?

A. The property still qualifies as your personal residence because: you owned the property for at least two of the five years before the sale; you occupied the property as your principal residence for at least two years during the five-year period ending on the date of sale (during the five-year period ending November 1, 2005, you lived in the house from 1999, through December 31, 2003, a period of over two years); and you have not used the gain exclusion for any residence during the two-year period ending on the date of sale. Therefore, you can exclude the gain because it is less than the $250,000 gain exclusion limitation. However, $20,000 of the gain is taxable because gain to the extent of the post-May 6, 1997, depreciation cannot be excluded.

The opinions expressed in this article are those of the authors and do not necessarily reflect the viewpoint of SFAA or SF Apartment Magazine. Doug Schultz is a certified public accountant and partner in the tax practice at Burr, Pilger & Mayer. Paul Fong is a certified public accountant and senior tax manager in the tax practice at Burr, Pilger & Mayer. Copyright © 2007 by SF Apartment Magazine. All rights reserved.