ask matt cpa we are free agents nation …

Whenever you sell things, you will pay tax on the profit.  Selling inventory is ordinary income, but selling investment asset is capital gain.  Capital gain is taxed at a lower rate.  Alright, so, what is the misery?  Capital gain is not always what you think it is.  It is sometimes just a phantom.

Current Rates

The highest federal tax rate for normal income is 35% (This is 2009 rate, and rumors has it 36% and 39.6% tax brackets could be restored).  Long term capital gain, however, is taxed at 15% in most of the case.  For people with lower income, the capital gain is 0%.

Little History & Trend

Tax codes are very susceptible to political influences.  Capital gain is a one of those favorite battle grounds on which our lawmakers like to wrestle .  Investor-friendly Congress tends to support lower capital gain taxes.

Before 2003, the rate for long term capital was 20% (10% and 8% for lower income), but after that, it was reduced to 15% (5% for lower income).  In 2008, the rate was changed to 0% for lower income filers.  After 2010, we should expect the rate to go back to 20% or more.  As tricky as it is, you can still count on it being lower than the normal income rates.

Easy Come, Easy Go

Smooth sailing so far.  However, as a real estate investor, you may be shocked that capital gain tax is not a simply multiplication (profit x 15%).  Now the true layers or other faces of capital gain calculation will show.

Remember the happy moment when you took the depreciation to offset your rental income?  Depreciation is one of the reason why real estate investment is attractive.  Most tax write-offs are attributed to actual expenses, but deprecation is not.  You only need the down payment to buy a property, but you can take deprecation on the full amount, even the portion you have not yet paid.

There is no free lunch.  IRS always knows where to wait for you to pay back.  They call it depreciation recapture, a term often giving me an imagination that a man in suit gloating cynically in my back.  

True Faces

Ok, here is how it works.  Normally total deprecation reduces a property’s costs basis and therefore gives you higher capital gain.  When you do the math for the tax, the gain has to be assigned to the two following categories first.

Section 1250 Deprecation Recapture

First, if the property was placed in service prior to 1986.  You have to find out the depreciation exceeding the amount calculated by a simple straight-line method.  This part is subtracted from the gain and taxed as normal income at higher rates.

Section 1250 Unrecaptured Gain

Secondly, the rest of the depreciation (by straight-line method) that you could have claimed, even thought you may forget to take in your prior tax returns, is also subtracted from the gain and taxed at a flat rate of 25%. 

Pure Capital Gain

As long as you have a capital gain, you should take care of these two layers of gain first, then the remaining is taxed as the true capital gain 15% rate.  If the first two layers of gain are greater than your total gain, the lower rate capital gain is in effect totally wiped out.

Need an example?  You may check out the wiki detail here. 

Morale of the story?  Sellers of investment property, be warned! An appreciating property that you have held for a long while can surprise you with an unexpected higher tax bill.  Be ready to get adequate liquidity to pay for the higher tax amount.  Plan for the tax-deferred strategies while you can (think 1031 exchange or installment sales).