The commercial classroom: Capital gains taxes - by Edward Smith

This column is offered to help educate agents new to commercial and investment brokerage and serve as a review of basics for existing practitioners.

Generally, when you sell the home you live in and any commercial property you own, it may be subject to capital gains taxes. Always, before you take a listing, advise your client to speak to their accountant about this.

Whenever one makes a capital improvement on property that you own, you need to keep detailed records, as this will be used in the calculation when you sell. Capital improvement are permanent structural changes or upgrades that add value to your property. For example: Adding a new room, garage, roof, windows, upgrading the electrical system, also interior renovations, building out space, in a home a new kitchen. Rule of thumb: the improvement must be useful for more than a year.

The capital gains taxes are either 15% or 20% depending on the income level of the appreciated value of the property. On commercial and investment property there is an additional tax of 25% on the recapture of the depreciation taken while the property was owned. There is no depreciation taken on the home you live in. 

Short-term capital gains are assets held for less than one year, they are taxed at the marginal rate (tax bracket) of the taxpayer’s income. Assets held to 12 months, or more are taxed based on the taxpayer’s Adjusted Gross Income (AGI). Currently the individual tax rates (brackets) range from 10% to 37%, these and the dollar amounts are subject to change each year, as are the dollar amounts for the capital gains tax brackets (15% or 20%).

Another tax that applies annually, will also need to be paid upon sale is the medicare surcharge. This is a tax on net investment income of 3.8%, on income over $200,000 if filing as a single taxpayer, and on income over $250,000 if filing as married filing jointly. These dollar amounts stay the same each year.

The rules and calculations for sale of your primary residence and the sale of commercial and investment property are different. First, we will look at the sale of the home you live in. There is a residential exclusion, homeowners may exclude the first $250,000 in gain ($500,000 if married and they file their income taxes jointly) on the sale of one home every two years. To be eligible, the home seller must have owned and resided in the home for two of the last five years before the sale.

The basis is the original cost of the property when it was purchased. An adjusted basis is the original cost plus certain additions and minus certain deductions. We begin with the purchase price and add to it the closing costs of the purchase at that time, next you add the costs of all capital improvements taken during your ownership, then we add in the cost of current sale (commissions, attorney fees, etc.) this results in the adjusted basis.

Next the adjusted basis is subtracted from the price you are selling your home for which results in the net profit. From this you subtract the capital gain exclusion if eligible. Any remaining gain will then be subject to the capital gain tax.

For example, a residential married couple who file their income taxes jointly bought a house 20 years ago for $125,000. At that time their closing costs were $6,250 and during ownership they added a room, a capital improvement of $30,000, the cost of the sale is $57,280, added together creating an adjusted basis of $218,780. This is subtracted from the sale price of $895,000, creating a net profit of $676,220. After the $500,000 capital gain exclusion the remaining capital gain is $176,220, which will be taxed at 15%, they now owe $26,455 in capital gain tax on the sale of their home.

Using the same numbers for a single taxpayer, from the net profit of $676,220 they subtract the capital gain exclusion of $250,000 creating a capital gain of $426,220. Still in the 15% tax bracket the tax is $63,933. However, since the capital gain exceeds the $250,000 exclusion by $226,220, this money will be subject to the medicare surtax of 3.8% adding another $8,596 to the total taxes on the sale of the home now totaling $72,529.

Two other issues, in a divorce where one spouse gets the house and is now selling it the IRS will consider this person as a single taxpayer. When a spouse dies the IRS will allow the remaining spouse to use the married couple exclusion if the home is sold within two years.

The capital gains taxes on commercial and investment properties adds an additional tax, called the recaptured depreciation tax. Depreciation taken reduces the “basis” of the building consequently increasing the taxable gain. Upon sale the depreciation taken while owning the building is recaptured and taxed at 25%.

Depreciation is also known as cost recovery. Land does not depreciate, the depreciation on a residential structure (multi-family, apartment building, mixed use if the residential portion is over 50%) is calculated over 27,5 years, other commercial properties are depreciated over 39 years. Capital improvements must also be depreciated the length of time varies. Some examples, structural components, roof, HVAC 39 years, Qualified Improved Property (QIP) interior renovations 15 years. Land improvements parking lots, fences, side walks 15 years, personal property 5-7 years.

An example of a commercial property follows using numbers similar to the residential example. A commercial building was bought 20 years ago for $125,000. It was improved in stages totaling $130,000. Today it is being sold for $895,000.

Step one is to determine the adjusted basis. The purchase price, plus closing costs at that time, plus improvement costs, plus cost of the current sale, less depreciation taken yields the adjusted basis. Because land does not depreciate, from the price of $125,000, $25,000 will be subtracted, representing the land value, creating an adjusted building value of $100,000. Depreciation on the building value of $100,000 is divided by 39 years, equaling $2,564 per year. Building depreciation for 20 years would be $51,282. Depreciation on the $130,000 capital improvements was calculated as $35,000 for a total depreciation on the building of $66, 282. Now we calculate the adjusted basis. Price $125,000, plus closing costs $6,250, plus improvements $130,000, plus cost of sale $57,280, less deprecation $86,282, creates an adjusted basis of $232,248.

Capital gain calculation: sale price $895,000, less adjusted basis $232,248, creates a net profit (capital gain from appreciation) of $662,752, which due to the amount is taxed at 20% for $132,550. The gain from depreciation of $86,282 is taxes at the depreciation recapture tax rate of 25% for $21,570. 

The medicare surtax of 3.8% would vary as to type of ownership. A single taxpayer with a $200,000 exclusion is taxed $17,585, married filing jointly with $250,000 exclusion is taxed $15,684. 

When added together: the gain from appreciation $132,550, gain from depreciation $21,570 and the medicare surtax of either $17,585 or $15,684, the capital gains tax on the $895,000 sale will be $169,804 or $171,705.

Plus, state capital gains taxes may apply too.

Before you list a home or commercial property for sale make sure your client discusses the possible capital gains taxes with their accountant or tax advisor. Next month we will look at a possible solution by doing a 1031 tax-deferred exchange.

Edward Smith Jr., CREI, ITI, CIC, GREEN, MICP, CNS, e-PRO, AHWD is a licensed real estate broker in New York and Connecticut with Smith Commercial Real Estate, Sandy Hook, CT.