Tax Example For Commercial Real Estate

First, if you buy and sell property and make a profit, you incur capital gains. Long-term capital gains are generally taxed at a rate lower than your personal income tax rate. That is a bonus and another reason to leave your 9 to 5 job and start a career in real estate. The IRS considers long-term investments as those lasting over a period of one year. Short-term capital gains are taxed at your normal income tax rate, which could be as high as 35 percent for some taxpayers.

Although the capital gains rate and holding periods seem to fluctuate with changing administrations, the recent tendency has been to keep the rate below your ordinary income tax rate. Before May 6, 2003, the rates were 20 percent for most long-term gains and 10 percent for taxpayers in the 15 percent category. Currently, the long-term capital gains rate is 15 percent for most taxpayers. If you fall into the 10 or 15 percent tax brackets, the capital gains rate is only 5 percent. The incentive is simple. Hold on to real estate longer than a year before selling to reduce your tax liability. For foreclosures and properties that you were planning to resell, it will be necessary to rent out the property for at least one year before selling. Capital gains occur when you buy a property and sell it for more than what you paid for it or the basis of the property. The basis can be affected by expenses, but for simplicity if you bought a property for $50,000 and sold it a few years later for $65,000, then you have incurred a capital gain of $15,000 and it will be taxed at 15 percent. So, you owe Uncle Sam $2,250.

That's pretty easy so far. Now, how about depreciation? If you depreciate a rental house, then there will come a day of reckoning. In essence, the government has loaned you money and now it's time to pay back your debt. Depreciation recovery is taxed at your tax rate, or 25 percent in most cases. In our previous example, you may have depreciated the property for a few years. Let's say the depreciation taken is $5,000. This $5,000 is recovered and taxed at 25 percent. To summarize, you bought an investment property at $50,000 and sold it for $65,000. You depreciated the property so that its new basis is now $45,000. You owe taxes on $20,000, but at two different rates as shown below: Investment Property Example Purchase Price = $50,000 Purchase Price Sale Price Tax Rate Taxes Due Appreciation = $15,000 15% $2,250 Original Basis = Depreciation = $5,000 25% $1,250 $50,000 New Basis = $45,000 Not Applicable $0 Total $3,500 So are there any ways around paying these taxes? The simple answer is yes.