Selling investment real estate can result in a rude awakening when it comes time to pay federal and state income taxes on the profit earned from the sale.
Income tax must be paid on the recognized gain. The gain is not necessarily measured by deducting the original cost of the real estate from the sales price. Instead, the original cost must be adjusted to compute the tax "basis" of the property.
Original cost is adjusted upward for money spent to improve the property to the extent these expenditures have not been deducted from property income for tax purposes in prior years. Further, the original cost must be reduced for depreciation expenses which have been deducted or could have been deducted from property income during the period of ownership.
Currently, the IRS requires that residential real estate buildings be depreciated over a minimum period of 27.5 years. Nonresidential real estate carries a minimum of 39 years depreciation in computing income taxes.
The effect of depreciation is to lower the tax basis of investment real estate and to increase the gain recognized on a sale. For example, let's say an investor bought residential investment real estate in 1992 for $100,000, of which $25,000 was allocated to the value of the land and $75,000 was allocated to the building. In 2001, the investor sold the property for $150,000. Although the investor might think his taxable gain is $50,000, he would be wrong.
Due to tax depreciation over the nine years of ownership, the taxable gain is approximately $75,000. The investor would have to pay capital gains tax on the recognized gain.
Tax on gain from investment real estate may be deferred by reinvesting the proceeds in another investment property costing at least as much as the sale property ($150,000 in the above example). The reinvestment must be accomplished in strict compliance with IRS regulations governing the tax-free exchange of investment property.
Alternatively, if the sale were structured on an installment basis, the selling investor would pay taxes on the gain as it is received, rather than all at once in the year of sale.
Before selling investment real estate, it's a good idea to review the transaction with your accountant or tax adviser to make sure you understand all of the tax consequences ahead of time.