Investment Property
How is the gain from the sale of investment property taxed?
You owe capital gains taxes on the difference between your adjusted cost basis and your net selling price. Under a year is short term (ordinary income tax rates)… over a year is long term capital gains rates.
Unearned income Medicare contribution tax ("net investment income tax") Tax percentage (3.80%) Above $200,000 Single / $250,000 MFJ apply this to any cap gains rates.
When you sell investment property, all of your profits are subject to either capital gains tax or depreciation recapture tax, which is a special type of capital gains tax. Your tax gets calculated on the difference between your cost basis and your selling price. Any debt that you owe, such as the balance on your mortgage, will not affect your capital gains liability.
https://finance.zacks.com/calculate-capital-gains-sale-investment-property-mortgage-owed-9381.html
What is depreciation recapture?
Publication 544 / page 29
Normally depreciation recapture on a rental property is typically 25% tax rate.
No recapture can be more than the actual profit.
If you dispose of depreciable or amortizable property at a gain, you may have to treat all or part of the gain (even if otherwise nontaxable) as ordinary income. To figure any gain that must be reported as ordinary income, you must keep permanent records of the facts necessary to figure the depreciation or amortization allowed or allowable on your property. This includes the date and manner of acquisition, cost or other basis, depreciation or amortization, and all other adjustments that affect basis.
How do I report income from a rental property?
If you rent real estate such as buildings, rooms or apartments, you normally report your rental income and expenses on Form 1040, Schedule E, Part I. List your total income, expenses, and depreciation for each rental property on the appropriate line of Schedule E. See the Instructions for Form 4562 to figure the amount of depreciation to enter on line 18.
How is interest on a rental property deducted?
Schedule E, 1.1 million loan value for personal use NOT rental use property.
Interest expense.
You can deduct mortgage interest you pay on your rental property. When you refinance a rental property for more than the previous outstanding balance, the portion of the interest allocable to loan proceeds not related to rental use generally can’t be deducted as a rental expense. Chapter 4 of Pub. 535 explains mortgage interest in detail.
You are claiming an expense this year for something you bought in a previous year. Accrual basis. There is no secured debt requirement for rental property. As long as you use the funds for rental property purposes you can deduct the interest as an expense on your schedule E.
If you receive rental income from the rental of a dwelling unit, there are certain rental expenses you may deduct on your tax return. These expenses may include mortgage interest, property tax, operating expenses, depreciation, and repairs.
You can deduct the ordinary and necessary expenses for managing, conserving and maintaining your rental property. Ordinary expenses are those that are common and generally accepted in the business. Necessary expenses are those that are deemed appropriate, such as interest, taxes, advertising, maintenance, utilities and insurance.
What are the rules for being able to deduct a loss on a rental property?
You can't take losses on rental property against other income.
Form 8582 instruction / page 3 middle
Special Allowance for Rental Real Estate Activities Active participation. If you actively participated in a passive rental real estate activity, you may be able to deduct up to $25,000 of loss from the activity from your non-passive income. This special allowance is an exception to the general rule disallowing losses in excess of income from passive activities.
What expenses are deductible for a rental property?
Types of Expenses Listed below are the most common rental expenses.
- Advertising.
- Auto and travel expenses.
- Cleaning and maintenance.
- Commissions.
- Depreciation.
- Insurance.
- Interest (other).
- Legal and other professional fees.
- Local transportation expenses.
- Management fees.
- Mortgage interest paid to banks, etc.
- Points.
- Rental payments.
- Repairs.
- Taxes.
- Utilities.
Some of these expenses, as well as other less common ones, are discussed below.
Publication 527 / Page 3 right
What is a mixed use property and how are the expenses allocated?
How to divide expenses - If an expense is for both rental use and personal use, such as mortgage interest or heat for the entire house, you must divide the expense between rental use and personal use.
What are the passive activity rules?
Generally, a passive activity is any rental activity OR any business in which the taxpayer does not materially participate. Non-passive activities are businesses in which the taxpayer works on a regular, continuous, and substantial basis.
If the taxpayer does not materially participate in the activity that is producing the passive losses, then those losses can only be matched against passive income. If there is no passive income, then no loss can be deducted. However, rental activities, including real estate rental activities, are considered passive activities even if there is material participation ("real estate professionals" cannot benefit from this exception).
Passive activity losses can only be applied in the current year, and if they exceed passive income they can be carried forward without limitation; they cannot be carried back.
In general, passive activity loss rules are applied at the individual level, but they also extend to virtually all businesses and rental activity in various reporting entities, except C corporations, in order to deter abusive tax shelters.
Income and losses from the following activities would generally be passive:
- Equipment leasing
- Rental real estate (with some exceptions)
- Sole proprietorship or farm in which the taxpayer does not materially participate
- Limited partnerships with some exceptions
- Partnerships, S-Corporations, and limited liability companies in which the taxpayer does not materially participate
Passive losses are carried forward. Unused passive losses become non passive losses and must be used in the year the property is sold. Any passive activity losses (but not credits) that have not been allowed (including current year losses) generally are allowed in full in the tax year you dispose of your entire interest in the passive (or former passive) activity.
However, for the losses to be allowed, you must dispose of your entire interest in the activity in a transaction in which all realized gain or loss is recognized. Also, the person acquiring the interest from you must not be related to you.
Publication 925 / page 11
What are the "at risk" rules?
Under Sec. 465, a taxpayer that engages in certain activities may deduct losses from those activities only to the extent the taxpayer is “at risk” for those activities at the end of the tax year. Any loss from one of these activities that is not allowed in that tax year under the at-risk rules is carried over and treated as a deduction allocable to the same activity in the next year. If losses from an at-risk activity are allowed, these losses are subject to recapture in later years if the at-risk amount is reduced below zero.
Taxpayers must carefully examine and track these activities to determine whether they are separate activities or whether they must be aggregated before applying the at-risk rules.
Taxpayers subject to at-risk rules -
Under Sec. 465(a)(1), the at-risk rules apply to individuals (including partners and S corporation shareholders), estates, trusts, and certain closely held corporations.
Closely held corporations. For this purpose, a C corporation is closely held if, at any time during the last half of the tax year, more than 50% in value of the outstanding stock is owned (directly or indirectly) by or for five or fewer individuals (i.e., using the personal holding company stock ownership rules of Sec. 542(a)(2)).
Leasing by closely held corporations. For a closely held corporation actively engaged in equipment leasing, the equipment leasing activity is treated as a separate activity; losses from this activity are not covered by the at-risk rules (Sec. 465(c)(4)).
Activities covered by the at-risk rules -
The at-risk rules apply to activities that taxpayers conduct as a trade or business or in the production of income, including:
- Holding, producing, or distributing motion picture films or videotapes;
- Farming;
- Leasing Sec. 1245 property, including personal property and certain other depreciable or amortizable tangible property;
- Exploring for (or exploiting) oil and gas; and
- Exploring for (or exploiting) geothermal deposits (for wells started after September 1978).
But the at-risk rules also cover any activity other than those described above that is carried on as a trade or business or for the production of income (Sec. 465(c)(3)).
What are the Section 1031 requirements?
Publication 544
An exchange of city property for farm property, or improved property for unimproved property, is a like kind exchange.
Like-Kind Property - There must be an exchange of like kind property. Like kind properties are properties of the same nature or character, even if they differ in grade or quality.
The exchange of real estate for real estate and the exchange of personal property for similar personal property are exchanges of like kind property. For example, the trade of land improved with an apartment house for land improved with a store building, or a panel truck for a pickup truck, is a like kind exchange.The rules for like kind exchanges do not apply to exchanges of the following property. Property you use for personal purposes, such as your home and your family car.
However, see below. Stock in trade or other property held primarily for sale, such as inventories, raw materials, and real estate held by dealers. Stocks, bonds, notes, or other securities or evidences of indebtedness, such as accounts receivable. Partnership interests. Certificates of trust or beneficial interest. Choses in action, such as a lawsuit in which you are the plaintiff. Certain tax-exempt use property subject to a lease. For more information, see section 470(e) of the Internal Revenue Code.
Identification requirement. You must identify the property to be received within 45 days after the date you transfer the property given up in the exchange. This period of time is called the identification period. Any property received during the identification period is considered to have been identified.
Qualified intermediary must hold the funds.
Identifying replacement property. You must identify the replacement property in a signed written document and deliver it to the person obligated to transfer the replacement property or any other person involved in the exchange other than you or a disqualified person.
Receipt requirement. The property must be received by the earlier of the following dates. The 180th day after the date on which you transfer the property given up in the exchange. The due date, including extensions, for your tax return for the tax year in which the transfer of the property given up occurs.
Disqualified persons - A disqualified person is a person who is any of the following. 1. Your agent at the time of the transaction. 2. A person who is related to you under the rules discussed in chapter 2 under Nondeductible loss, substituting “10%” for “50%.” 3. A person who is related to a person who is your agent at the time of the transaction under the rules discussed in chapter 2 under Nondeductible loss, substituting “10%” for “50%.”
If a member holds funds then it will become a taxable event. Broker = you.
For purposes of (1) above, a person who has acted as your employee, attorney, accountant, investment banker or broker, or real estate agent or broker within the 2year period ending on the date of the transfer of the first of the relinquished properties is your agent at the time of the transaction.
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Whenever you sell business or investment property and you have a gain, you generally have to pay tax on the gain at the time of sale. IRC Section 1031 provides an exception and allows you to postpone paying tax on the gain if you reinvest the proceeds in similar property as part of a qualifying like-kind exchange. Gain deferred in a like-kind exchange under IRC Section 1031 is tax-deferred, but it is not tax-free.
The exchange can include like-kind property exclusively or it can include like-kind property along with cash, liabilities and property that are not like-kind. If you receive cash, relief from debt, or property that is not like-kind, however, you may trigger some taxable gain in the year of the exchange. There can be both deferred and recognized gain in the same transaction when a taxpayer exchanges for like-kind property of lesser value.
This fact sheet, the 21st in the Tax Gap series, provides additional guidance to taxpayers regarding the rules and regulations governing deferred like-kind exchanges.
Who qualifies for the Section 1031 exchange?
Owners of investment and business property may qualify for a Section 1031 deferral. Individuals, C corporations, S corporations, partnerships (general or limited), limited liability companies, trusts and any other taxpaying entity may set up an exchange of business or investment properties for business or investment properties under Section 1031.
What are the different structures of a Section 1031 Exchange?
To accomplish a Section 1031 exchange, there must be an exchange of properties. The simplest type of Section 1031 exchange is a simultaneous swap of one property for another.
Deferred exchanges are more complex but allow flexibility. They allow you to dispose of property and subsequently acquire one or more other like-kind replacement properties.
To qualify as a Section 1031 exchange, a deferred exchange must be distinguished from the case of a taxpayer simply selling one property and using the proceeds to purchase another property (which is a taxable transaction). Rather, in a deferred exchange, the disposition of the relinquished property and acquisition of the replacement property must be mutually dependent parts of an integrated transaction constituting an exchange of property. Taxpayers engaging in deferred exchanges generally use exchange facilitators under exchange agreements pursuant to rules provided in the Income Tax Regulations. .
A reverse exchange is somewhat more complex than a deferred exchange. It involves the acquisition of replacement property through an exchange accommodation titleholder, with whom it is parked for no more than 180 days. During this parking period the taxpayer disposes of its relinquished property to close the exchange.
What property qualifies for a Like-Kind Exchange?
Both the relinquished property you sell and the replacement property you buy must meet certain requirements.
Both properties must be held for use in a trade or business or for investment. Property used primarily for personal use, like a primary residence or a second home or vacation home, does not qualify for like-kind exchange treatment.
Both properties must be similar enough to qualify as "like-kind." Like-kind property is property of the same nature, character or class. Quality or grade does not matter. Most real estate will be like-kind to other real estate. For example, real property that is improved with a residential rental house is like-kind to vacant land. One exception for real estate is that property within the United States is not like-kind to property outside of the United States. Also, improvements that are conveyed without land are not of like kind to land.
Real property and personal property can both qualify as exchange properties under Section 1031; but real property can never be like-kind to personal property. In personal property exchanges, the rules pertaining to what qualifies as like-kind are more restrictive than the rules pertaining to real property. As an example, cars are not like-kind to trucks.
Finally, certain types of property are specifically excluded from Section 1031 treatment. Section 1031 does not apply to exchanges of:
Inventory or stock in trade
Stocks, bonds, or notes
Other securities or debt
Partnership interests
Certificates of trust
What are the time limits to complete a Section 1031 Deferred Like-Kind Exchange?
While a like-kind exchange does not have to be a simultaneous swap of properties, you must meet two time limits or the entire gain will be taxable. These limits cannot be extended for any circumstance or hardship except in the case of presidentially declared disasters.
The first limit is that you have 45 days from the date you sell the relinquished property to identify potential replacement properties. The identification must be in writing, signed by you and delivered to a person involved in the exchange like the seller of the replacement property or the qualified intermediary. However, notice to your attorney, real estate agent, accountant or similar persons acting as your agent is not sufficient.
Replacement properties must be clearly described in the written identification. In the case of real estate, this means a legal description, street address or distinguishable name. Follow the IRS guidelines for the maximum number and value of properties that can be identified.
The second limit is that the replacement property must be received and the exchange completed no later than 180 days after the sale of the exchanged property or the due date (with extensions) of the income tax return for the tax year in which the relinquished property was sold, whichever is earlier. The replacement property received must be substantially the same as property identified within the 45-day limit described above.
Are there restrictions for deferred and reverse exchanges?
It is important to know that taking control of cash or other proceeds before the exchange is complete may disqualify the entire transaction from like-kind exchange treatment and make ALL gain immediately taxable.
If cash or other proceeds that are not like-kind property are received at the conclusion of the exchange, the transaction will still qualify as a like-kind exchange. Gain may be taxable, but only to the extent of the proceeds that are not like-kind property.
One way to avoid premature receipt of cash or other proceeds is to use a qualified intermediary or other exchange facilitator to hold those proceeds until the exchange is complete.
You can not act as your own facilitator. In addition, your agent (including your real estate agent or broker, investment banker or broker, accountant, attorney, employee or anyone who has worked for you in those capacities within the previous two years) can not act as your facilitator.
Be careful in your selection of a qualified intermediary as there have been recent incidents of intermediaries declaring bankruptcy or otherwise being unable to meet their contractual obligations to the taxpayer. These situations have resulted in taxpayers not meeting the strict timelines set for a deferred or reverse exchange, thereby disqualifying the transaction from Section 1031 deferral of gain. The gain may be taxable in the current year while any losses the taxpayer suffered would be considered under separate code sections.
How do you compute the basis in the new property?
It is critical that you and your tax representative adjust and track basis correctly to comply with Section 1031 regulations.
Gain is deferred, but not forgiven, in a like-kind exchange. You must calculate and keep track of your basis in the new property you acquired in the exchange.
The basis of property acquired in a Section 1031 exchange is the basis of the property given up with some adjustments. This transfer of basis from the relinquished to the replacement property preserves the deferred gain for later recognition. A collateral affect is that the resulting depreciable basis is generally lower than what would otherwise be available if the replacement property were acquired in a taxable transaction.
When the replacement property is ultimately sold (not as part of another exchange), the original deferred gain, plus any additional gain realized since the purchase of the replacement property, is subject to tax.
How do you report Section 1031 Like-Kind Exchanges to the IRS?
You must report an exchange to the IRS on Form 8824, Like-Kind Exchanges and file it with your tax return for the year in which the exchange occurred.
Form 8824 asks for:
Descriptions of the properties exchanged
Dates that properties were identified and transferred
Any relationship between the parties to the exchange
Value of the like-kind and other property received
Gain or loss on sale of other (non-like-kind) property given up
Cash received or paid; liabilities relieved or assumed
Adjusted basis of like-kind property given up; realized gain
If you do not specifically follow the rules for like-kind exchanges, you may be held liable for taxes, penalties, and interest on your transactions.
https://www.irs.gov/newsroom/like-kind-exchanges-under-irc-code-section-1031
What type of property qualifies for Section 1031 treatment?
Generally, if you exchange business or investment property solely for business or investment property of a like-kind, no gain or loss is recognized under Internal Revenue Code Section 1031. If, as part of the exchange, you also receive other (not like-kind) property or money, gain is recognized to the extent of the other property and money received, but a loss is not recognized.
Section 1031 does not apply to exchanges of inventory, stocks, bonds, notes, other securities or evidence of indebtedness, or certain other assets.
Like-Kind Property
Properties are of like-kind, if they are of the same nature or character, even if they differ in grade or quality. Personal properties of a like class are like-kind properties.
However, livestock of different sexes are not like-kind properties. Also, personal property used predominantly in the United States and personal property used predominantly outside the United States are not like-kind properties.
Real properties generally are of like-kind, regardless of whether the properties are improved or unimproved. However, real property in the United States and real property outside the United States are not like-kind properties.
Topic Number 415 - Renting Residential and Vacation Property
If you receive rental income for the use of a dwelling unit, such as a house or an apartment, you may deduct certain expenses. These expenses, which may include mortgage interest, real estate taxes, casualty losses, maintenance, utilities, insurance, and depreciation, will reduce the amount of rental income that's subject to tax. You'll generally report such income and expenses on Form 1040.pdf, U.S. Individual Income Tax Return, and on Form 1040, Schedule E.pdf, Supplemental Income and Loss. If you're renting to make a profit and don't use the dwelling unit as a residence, then your deductible rental expenses may be more than your gross rental income. Your rental losses, however, generally will be limited by the "at-risk" rules and/or the passive activity loss rules. For information on these limits, refer to Publication 925, Passive Activities and At-Risk Rules.
Rental Property / Personal Use
If you rent a dwelling unit to others that you also use as a residence, limitations may apply to the rental expenses you can deduct. You're considered to use a dwelling unit as a residence if you use it for personal purposes during the tax year for more than the greater of:
- 14 days, or
- 10% of the total days you rent it to others at a fair rental price.
It's possible that you'll use more than one dwelling unit as a residence during the year. For example, if you live in your main home for 11 months, your home is a dwelling unit used as a residence. If you live in your vacation home for the other 30 days of the year, your vacation home is also a dwelling unit used as a residence unless you rent your vacation home to others at a fair rental value for 300 or more days during the year in this example.
A day of personal use of a dwelling unit is any day that it's used by:
- You or any other person who has an interest in it, unless you rent your interest to another owner as his or her main home and the other owner pays a fair rental price under a shared equity financing agreement
- A member of your family or of a family of any other person who has an interest in it, unless the family member uses it as his or her main home and pays a fair rental price
- Anyone under an agreement that lets you use some other dwelling unit
- Anyone at less than fair rental price
Minimal Rental Use
There's a special rule if you use a dwelling unit as a residence and rent it for fewer than 15 days. In this case, don't report any of the rental income and don't deduct any expenses as rental expenses.
Dividing Expenses between Rental and Personal Use
If you use the dwelling unit for both rental and personal purposes, you generally must divide your total expenses between the rental use and the personal use based on the number of days used for each purpose. You won't be able to deduct your rental expense in excess of the gross rental income limitation (your gross rental income less the rental portion of mortgage interest, real estate taxes, and casualty losses, and rental expenses like realtors' fees and advertising costs). However, you may be able to carry forward some of these rental expenses to the next year, subject to the gross rental income limitation for that year. If you itemize your deductions on Form 1040, Schedule A.pdf, Itemized Deductions, you may still be able to deduct your personal portion of mortgage interest, property taxes, and casualty losses on that schedule.
Business Use of Home
Another special rule applies if you rent part of your home to your employer and provide services for your employer in that rented space. In this case, report the rental income. You can deduct mortgage interest, qualified mortgage insurance premiums, real estate taxes, and personal casualty losses for the rented part, subject to any limitations, but don't deduct any business expenses. For information on these limits, refer to Publication 587, Business Use of Your Home (Including Use by Daycare Providers).
Net Investment Income Tax
If you have a rental income, you may be subject to the Net Investment Income Tax (NIIT). For more information, refer to Topic No. 559.
Additional Information
For more information on offering residential property for rent, refer to Publication 527, Residential Rental Property (Including Rental of Vacation Homes).
For more information on residential rental property income and expenses, refer to Topic No. 414 and Is My Residential Rental Income Taxable and/or Are My Expenses Deductible?
https://www.irs.gov/taxtopics/tc415