The Biden administration is proposing an increase to long-term capital gains tax. Tax basis and capital gains for investment properties are commonly misunderstood. Before you consider selling an investment property, it’s important to understand how gain is calculated. Here’s a quick look at this topic and sample calculations.
Tax Basis Is a Moving Number
Many people mistakenly think that capital gains tax is based solely on initial purchase price versus ending sale price. It’s actually a bit more complicated than that. The figure used to calculate gain, also known as tax basis, is a moving number. It starts with the initial purchase price. The figure is increased by repairs and capital improvements. Each year, as you take depreciation deductions on your tax return, this reduces the tax basis. Based on these activities, the tax basis changes from year to year. You must track those changes.
For instance, let’s assume you purchase a multi-family property for $500,000. During the first year, you complete $50k worth of repairs. The tax basis is now $550,000. If you take a depreciation deduction of $12,000. The tax basis drops to $538,000. Note that only building value can be depreciated, not land value. As you can see, tax basis will constantly change. If you own the building long enough, you will eventually depreciate the entire building and capital improvements, leaving only the land value.
Once you have the tax basis figured out, it’s much easier to estimate the capital gain. First take your sale price and minus expenses. For instance, if you sell your property for $8000 and pay $45,000 in commissions and closing costs, that leaves $755,000 as the net earnings from the sale. The next step is to subtract the tax basis. For a tax basis of $538,000, then your taxable gain is $217,000 ($755k minus $538k).
Long Term Capital Gains Tax
The capital gains tax rate depends on your income bracket. It can be 0%, 15%, or 20%. So, on a $217,000 gain, that could mean up to $43,400 in taxes for a $217k gain. Under the 2021 proposed tax changes, this amount could increase to 39.6% ($85,932 on a $217k gain). There’s also Massachusetts capital gains tax of 5.1%. If your adjusted gross income is greater than $200,000, there’s a surtax of 3.8% as well. All of this adds up quickly and depletes your net earnings from selling a multi-family investment property, which is why it’s so important to understand tax implications when evaluating the benefits of selling an investment property.
More on Tax Basis and Capital Gains for Investment Properties
The examples above are simplified for illustration purposes only. Tax laws are quite complex and involve much more than the few elements we’ve mentioned above. It’s extremely important that you consult with your account and tax advisor for estimates specific to your financial situation and tax bracket. As of the writing of this article, the 2021 tax changes were not yet approved. Tax laws are always changing, so be sure to rely on the most current information before making investment decisions. This also avoids unexpected surprises come tax time.