Disclaimer and Warning - From Bob Parrish CPA, P.C.
Remember........"You can have everything in life you want, if you just help enough other people get what they want." -Zig Ziglar.
Email: bmsarasota@comcast.net 941-387-0926; 432-367-3465 email, USA Mail, Fax, telephone or request a meeting
What is the tax rate for the sale of real estate?
Gain on the disposition of section 1250 property is treated as ordinary income to the extent of additional depreciation allowed or allowable on the property. To determine the additional depreciation on section 1250 property, see Additional Depreciation, later.
You will not have additional depreciation if any of the following conditions apply to you.
Section 1250 property. This includes all real property that is subject to an allowance for depreciation and that is not and never has been section 1245 property. It includes a leasehold of land or section 1250 property subject to an allowance for depreciation. A fee simple interest in land is not included because it is not depreciable.
If your section 1250 property becomes section 1245 property because you change its use, you can never again treat it as section 1250 property.
To find what part of the gain from the disposition of section 1250 property is treated as ordinary income, follow these steps.
Use Part III, Form 4797, to figure the ordinary income part of the gain.
Corporations. Corporations, other than S corporations, have an additional amount to recognize as ordinary income on the sale or other disposition of section 1250 property. The additional amount treated as ordinary income is 20% of the excess of the amount that would have been ordinary income if the property were section 1245 property over the amount treated as ordinary income under section 1250. Report this additional ordinary income on line 26(f) of Form 4797, Part III.
If you hold section 1250 property longer than 1 year, the additional depreciation is the actual depreciation adjustments that are more than the depreciation figured using the straight line method. For a list of items treated as depreciation adjustments, see Depreciation and amortization under Gain Treated as Ordinary Income, earlier.
If you hold section 1250 property for 1 year or less, all the depreciation is additional depreciation.
You will have additional depreciation if you use the regular ACRS method, the declining balance method, the sum-of-the-years-digits method, the units-of-production method, or any other method of rapid depreciation. You also have additional depreciation if you choose amortization, other than amortization on real property that qualifies as section 1245 property, discussed earlier.
Depreciation taken by other taxpayers or on other property. Additional depreciation includes all depreciation adjustments to the basis of section 1250 property whether allowed to you or another person (as for carryover basis property).
Example. Larry Johnson gives his son section 1250 property on which he took $2,000 in depreciation deductions, of which $500 is additional depreciation. Immediately after the gift, the son's adjusted basis in the property is the same as his father's and reflects the $500 additional depreciation. On January 1 of the next year, after taking depreciation deductions of $1,000 on the property, of which $200 is additional depreciation, the son sells the property. At the time of sale, the additional depreciation is $700 ($500 allowed the father plus $200 allowed the son).
Depreciation allowed or allowable. The greater of depreciation allowed or allowable (to any person who held the property if the depreciation was used in figuring its adjusted basis in your hands) is generally the amount to use in figuring the part of the gain to be reported as ordinary income. If you can show that the deduction allowed for any tax year was less than the amount allowable, the lesser figure will be the depreciation adjustment for figuring additional depreciation.
Retired or demolished property. The adjustments reflected in adjusted basis generally do not include deductions for depreciation on retired or demolished parts of section 1250 property unless these deductions are reflected in the basis of replacement property that is section 1250 property.
Example. A wing of your building is totally destroyed by fire. The depreciation adjustments figured in the adjusted basis of the building after the wing is destroyed do not include any deductions for depreciation on the destroyed wing unless it is replaced and the adjustments for depreciation on it are reflected in the basis of the replacement property.
Figuring straight line depreciation. The useful life and salvage value you would have used to figure straight line depreciation are the same as those used under the depreciation method you actually used. If you did not use a useful life under the depreciation method actually used (such as with the units-of-production method) or if you did not take salvage value into account (such as with the declining balance method), the useful life or salvage value for figuring what would have been the straight line depreciation is the useful life and salvage value you would have used under the straight line method.
Salvage value and useful life are not used for the ACRS method of depreciation. Figure straight line depreciation for ACRS real property by using its 15-, 18-, or 19-year recovery period as the property's useful life.
The straight line method is applied without any basis reduction for the investment credit.
Property held by lessee. If a lessee makes a leasehold improvement, the lease period for figuring what would have been the straight line depreciation adjustments includes all renewal periods. This inclusion of the renewal periods cannot extend the lease period taken into account to a period that is longer than the remaining useful life of the improvement. The same rule applies to the cost of acquiring a lease.
The term "renewal period" means any period for which the lease may be renewed, extended, or continued under an option exercisable by the lessee. However, the inclusion of renewal periods cannot extend the lease by more than two-thirds of the period that was the basis on which the actual depreciation adjustments were allowed.
Rehabilitation expenses. A part of the special 60-month depreciation adjustment allowed for rehabilitation expenses incurred before 1987 in connection with low-income rental housing is additional depreciation. The additional depreciation is the special depreciation adjustments that are more than the adjustments that would have resulted if the straight line method, normal useful life, and salvage value had been used.
Example. On January 5, 2001, Fred Plums, a calendar year taxpayer, sold real property in which the entire basis was from rehabilitation expenses of $40,000 incurred in 1985. The property was placed in service on January 3, 1986. Under the special depreciation provisions for rehabilitation expenses, the property was depreciated under the straight line method using a useful life of 60 months (5 years) and no salvage value. If Fred had used the regular straight line method, he would have used a salvage value of $4,000 and a useful life of 15 years, and would have had a depreciable basis of $36,000. Depreciation under the straight line method would have been $2,400 each year (1/15 ? $36,000). On January 1, 2001, the additional depreciation for the property was $4,000, figured as follows.
| Depreciation | Straight Line | Additional | |
| Claimed | Depreciation | Depreciation | |
| 1986 | 8,000 | 2,400 | 5,600 |
| 1987 | 8,000 | 2,400 | 5,600 |
| 1988 | 8,000 | 2,400 | 5,600 |
| 1989 | 8,000 | 2,400 | 5,600 |
| 1990 | 8,000 | 2,400 | 5,600 |
| 1991 | 2,400 | (2,400) | |
| 1992 | 2,400 | (2,400) | |
| 1993 | 2,400 | (2,400) | |
| 1994 | 2,400 | (2,400) | |
| 1995 | 2,400 | (2,400) | |
| 1996 | 2,400 | (2,400) | |
| 1997 | 2,400 | (2,400) | |
| 1998 | 2,400 | (2,400) | |
| 1999 | 2,400 | (2,400) | |
| 2000 | 2,400 | (2,400) | |
| Total | $40,000 | $36,000 | $ 4,000 |
The applicable percentage used to figure the ordinary income because of additional depreciation depends on whether the real property you disposed of is nonresidential real property, residential rental property, or low-income housing. The percentages for these types of real property are as follows.
Nonresidential real property. For real property that is not residential rental property, the applicable percentage for periods after 1969 is 100%. For periods before 1970, the percentage is zero and no ordinary income because of additional depreciation before 1970 will result from its disposition.
Residential rental property. For residential rental property (80% or more of the gross income is from dwelling units) other than low-income housing, the applicable percentage for periods after 1975 is 100%. The percentage for periods before 1976 is zero. Therefore, no ordinary income because of additional depreciation before 1976 will result from a disposition of residential rental property.
Low-income housing. Low-income housing includes all the following types of residential rental property.
The applicable percentage for low-income housing is 100% minus 1% for each full month the property was held over 100 full months. If you have held low-income housing at least 16 years and 8 months, the percentage is zero and no ordinary income will result from its disposition.
Foreclosure. If low-income housing is disposed of because of foreclosure or similar proceedings, the monthly applicable percentage reduction is figured as if you disposed of the property on the starting date of the proceedings.
Example. On June 1, 1989, you acquired low-income housing property. On April 3, 2000 (130 months after the property was acquired), foreclosure proceedings were started on the property and on December 3, 2001 (150 months after the property was acquired), the property was disposed of as a result of the foreclosure proceedings. The property qualifies for a reduced applicable percentage because it was held more than 100 full months. The applicable percentage reduction is 30% (130 months minus 100 months) rather than 50% (150 months minus 100 months) because it does not apply after April 3, 2000, the starting date of the foreclosure proceedings. Therefore, 70% of the additional depreciation is treated as ordinary income.
Holding period. The holding period used to figure the applicable percentage for low-income housing generally starts on the day after you acquired it. For example, if you bought low-income housing on January 1, 1985, the holding period starts on January 2, 1985. If you sold it on January 2, 2001, the holding period is exactly 192 full months. The applicable percentage for additional depreciation is 8%, or 100% minus 1% for each full month the property was held over 100 full months.
Holding period for constructed, reconstructed, or erected property. The holding period used to figure the applicable percentage for low-income housing you constructed, reconstructed, or erected starts on the first day of the month it is placed in service in a trade or business, in an activity for the production of income, or in a personal activity.
Property acquired by gift or received in a tax-free transfer. For low-income housing you acquired by gift or in a tax-free transfer the basis of which is figured by reference to the basis in the hands of the transferor, the holding period for the applicable percentage includes the holding period of the transferor.
If the adjusted basis of the property in your hands just after acquiring it is more than its adjusted basis to the transferor just before transferring it, the holding period of the difference is figured as if it were a separate improvement. See Low-Income Housing With Two or More Elements, next.
If you dispose of low-income housing property that has two or more separate elements, the applicable percentage used to figure ordinary income because of additional depreciation may be different for each element. The gain to be reported as ordinary income is the sum of the ordinary income figured for each element.
The following are the types of separate elements.
The 36-month test for separate improvements. A separate improvement is an improvement (qualifying under The 1-year test, below) added to the capital account of the property if the total of the improvements during the 36-month period ending on the last day of any tax year is more than the greatest of the following amounts.
The 1-year test. An addition to the capital account for any tax year (including a short tax year) is treated as an improvement only if the sum of all additions for the year is more than the greater of $2,000 or 1% of the unadjusted basis of the property. The unadjusted basis is figured as of the start of that tax year or the holding period of the property, whichever is later. In applying the 36-month test, improvements in any one of the 3 years are omitted entirely if the total improvements in that year do not qualify under the 1-year test.
Example. The unadjusted basis of a calendar year taxpayer's property was $300,000 on January 1, 1988. During that year, the taxpayer made improvements A, B, and C, which cost $1,000, $600, and $700, respectively. Since the sum of the improvements, $2,300, is less than 1% of the unadjusted basis ($3,000), the improvements in 1988 do not satisfy the 1-year test and are not treated as improvements for the 36-month test. However, if improvement C had cost $1,500, the sum of the 1988 improvements would have been $3,100. It would then be necessary to apply the 36-month test to figure if the improvements must be treated as separate improvements.
Aditioto the capital account. Any addition to the capital account made after the initial acquisition or completion of the property by you or any person who held the property during a period included in your holding period is to be considered when figuring the total amount of separate improvements.
The addition to the capital account of depreciable real property is the gross addition not reduced by amounts attributable to replaced property. For example, if a roof with an adjusted basis of $20,000 is replaced by a new roof costing $50,000, the improvement is the gross addition to the account, $50,000, and not the net addition of $30,000. The $20,000 adjusted basis of the old roof is no longer reflected in the basis of the property. The status of an addition to the capital account is not affected by whether it is treated as a separate property for determining depreciation deductions.
Whether an expense is treated as an addition to the capital account may depend on the final disposition of the entire property. If the expense item property and the basic property are sold in two separate transactions, the entire section 1250 property is treated as consisting of two distinct properties.
nadjusted basis. In figuring the unadjusted basis as of a certain date, include the actual cost of all previous additions to the capital account plus those that did not qualify as separate improvements. However, the cost of components retired before that date is not included in the unadjusted basis.
Holding period. Use the following guidelines for figuring the applicable percentage for property with two or more elements.
If an improvement by itself does not meet the 1-year test (greater of $2,000 or 1% of the unadjusted basis), but it does qualify as a separate improvement that is a separate element (when grouped with other improvements made during the tax year), determine the start of its holding period as follows. Use the first day of a calendar month that is the closest first day of a month to the middle of the tax year. If there are two first days of a month that are equally close to the middle of the year, use the earlier date.
Figuring ordinary income attributable to each separate element. Figure ordinary income attributable to each separate element as follows.
Step 1. Divide the element's additional depreciation after 1975 by the sum of all the elements' additional depreciation after 1975 to determine the percentage used in Step 2.
Step 2. Multiply the percentage figured in Step 1 by the lesser of the additional depreciation after 1975 for the entire property or the gain from disposition of the entire property (the difference between the fair market value or amount realized and the adjusted basis).
Step 3. Multiply the result in Step 2 by the applicable percentage for the element.
Example. You sold at a gain of $25,000 low-income housing property subject to the ordinary income rules of section 1250. The property consisted of four elements (W, X, Y, and Z).
Step 1. The additional depreciation for each element is: W--$12,000; X--None; Y--$6,000; and Z--$6,000. The sum of the additional depreciation for all the elements is $24,000.
Step 2. The depreciation deducted on element X was $4,000 less than it would have been under the straight line method. Additional depreciation on the property as a whole is $20,000 ($24,000 - $4,000). Because $20,000 is lower than the $25,000 gain on the sale, $20,000 is used in Step 2.
Step 3. The applicable percentages to be used in Step 3 for the elements are: W--68%; X--85%; Y--92%; and Z--100%.
From these facts, the sum of the ordinary income for each element is figured as follows.
| Step 1 | Step 2 | Step 3 | Ordinary Income | |
| W | .50 | $10,000 | 68% | $ 6,800 |
| X | -0- | -0- | 85% | -0- |
| Y | .25 | 5,000 | 92% | 4,600 |
| Z | .25 | 5,000 | 100% | 5,000 |
| Sum of ordinary income of separate elements | $16,400 | |||
If you dispose of more than one asset in a single transaction, you must separately figure the gain on each asset so that it may be properly reported. To do this, allocate the selling price and the payments you receive in the year of sale to each asset. Report any depreciation recapture income in the year of sale before using the installment method for any remaining gain.
For a detailed discussion of installment sales, see Publication 537.