Tony's Tax Tips

The Tax Chess Board Part 5

This article originally appeared in the Pasadena Star News on April 29, 2006.
THE TAX CHESS BOARD – Owning real estate can increase your net worth without paying any income tax. In order to pay the least amount of tax, you have to understand the tax consequences of the various methods of disposing of real estate.
C. Anthony Phillips, CPA
SELL FOR CASH – For tax purposes, this is not the best method of transferring investment real estate. You will have to pay capital gains tax by the due date of your next tax return. Most people think they will be taxed at the 15% capital gains tax rate for Federal tax. What they don’t realize is that the Federal government reduced the capital gains tax rate from 20% to 15%, but the depreciation recapture rate remained at 25%.

DEPRECIATION RECAPTURE - If you own investment real estate, you will generally depreciate the portion of the purchase price you have allocated to buildings and other improvements. The amount of depreciation you have taken during your ownership of an investment property is accumulated for tax purposes. It is possible that some of your depreciation may be subject to recapture and taxed at 25%. Any gain that exceeds this accumulated depreciation is taxed at 15%.

EXAMPLE OF DEPRECIATION RECAPTURE - Assume you own a property that you purchased for $500,000 and sell for $600,000. Also assume you have $50,000 of depreciation that is subject to recapture. When you report the sale on your tax return, you would compute the amount of gain by subtracting $50,000 from $500,000 and subtracting the resulting amount of $450,000 from the sale price of $600,000. The resulting gain of $150,000 has to be divided into two income categories: the first amount is the recapture of the depreciation of $50,000. This amount is taxed at a maximum tax rate of 25% or $12,500. The balance of the gain, $150,000 less $50,000 or $100,000, is taxed at a maximum tax rate of 15% or $15,000. The total federal income tax would be $12,500 plus $15,000 or $27,500.

ALTERNATIVE MINIMUM TAX - More and more individuals have to pay alternative minimum tax, primarily because of the amount of state income tax they deducted. The above calculation does not take into consideration the additional amount of alternative minimum tax you might pay.

CALIFORNIA STATE TAX – In most cases, if you sell California real estate, 3.33% is withheld on the sale price or cash received and paid to the State. Generally, you will find that you are making an interest free loan to the State of California until you receive your refund, if the amount withheld exceeds the amount you owe.

Tony Phillips, CPA has a certified public accounting firm, Phillips & Company in Pasadena and is President of Downstream Exchange Company which helps investors save taxes when they sell their investment property.

The above is not intended to be used by any taxpayer for the purpose of avoiding penalties that may be imposed on the taxpayer.