Uncategorized

When selling real estate that has been held for over a year, you may anticipate paying federal income tax at the standard long-term capital gains rates of 15% or 20%. This rate typically applies to assets held beyond one year. However, if your real estate investment is held through a pass-through entity such as an LLC, partnership, or S corporation, the tax implications may vary. It’s important to understand the potential complexities involved in taxing real estate gains, particularly when depreciation deductions are factored in. Below is an overview of the federal income tax considerations associated with different types of real estate gains.

1. Vacant Land

For the sale of vacant land, the maximum federal long-term capital gains tax rate is 20%. This rate applies only to high-income individuals. In 2024, for a single filer, the 20% rate applies if taxable income—including any gains from land sales and other long-term capital gains—exceeds $518,900. For married couples filing jointly, the 20% rate applies when taxable income surpasses $583,750. Heads of households will face this rate if taxable income exceeds $551,350. If your income is below these thresholds, the maximum federal tax rate on land sale gains is 15%. Additionally, you may be subject to the 3.8% Net Investment Income Tax (NIIT) on some or all of the gain.

2. Gains Attributable to Depreciation

Gains resulting from real estate depreciation, calculated using the straight-line method, fall under the category of unrecaptured Section 1250 gain. This type of gain is generally taxed at a flat 25% federal rate unless it would be taxed at a lower rate if included in taxable income without special treatment. The 3.8% NIIT may also apply to some or all of the unrecaptured Section 1250 gain.

3. Gains from Depreciable Qualified Improvement Property (QIP)

Qualified Improvement Property (QIP) refers to improvements made to the interior of a nonresidential building placed in service after the building’s initial service date. However, QIP excludes expenditures for enlarging the building, adding elevators, escalators, or modifying the building’s structural framework.

When QIP is sold, gains may be impacted by prior depreciation deductions. Specifically:

• Section 179 Deductions: If first-year Section 179 deductions were claimed for QIP, the gain up to the amount of these deductions will be subject to high-taxed Section 1245 ordinary income recapture. This means the gain will be taxed at your ordinary income tax rate rather than the lower long-term capital gain rates. The 3.8% NIIT may also apply.
• Bonus Depreciation: For QIP with first-year bonus depreciation, gains up to the excess of bonus depreciation over straight-line depreciation will be subject to high-taxed Section 1250 ordinary income recapture. Similar to Section 179 deductions, this gain will be taxed at your regular income rate, and the 3.8% NIIT may apply.

Tax Planning Considerations

Opting for straight-line depreciation for real property, including QIP, avoids Section 1245 and Section 1250 ordinary income recapture. Consequently, the gain will be classified as unrecaptured Section 1250 gain, taxed at a maximum federal rate of 25%. However, the 3.8% NIIT may still apply to all or part of this gain.

Conclusion

The federal income tax implications of real estate transactions can be intricate, involving various tax rates and potential additional taxes such as the NIIT. Navigating these complexities requires careful planning and consideration. Our team is here to assist with the details of your tax return preparation. Please contact us with any questions regarding your specific situation.

© 2024

The forthcoming presidential and congressional elections may have a substantial impact on the tax landscape for U.S. businesses. A key factor in the potential shift is a tax provision set to expire in approximately 17 months and how Washington politicians might address it. 

Background

The Tax Cuts and Jobs Act (TCJA), which generally took effect in 2018, introduced significant changes to small business taxation. Many provisions within the TCJA are scheduled to expire on December 31, 2025.

As this expiration date approaches, you might be concerned about how future federal tax changes could affect your business. The uncertainty stems from differing perspectives between Democrats and Republicans on how to handle the TCJA’s various provisions.

Corporate and Pass-Through Business Rates

The TCJA reduced the maximum corporate tax rate from 35% to 21%. It also lowered the tax rates for individual taxpayers involved in non-corporate pass-through entities, such as S corporations, partnerships, and sole proprietorships. The highest individual rate is now 37%, down from 39.6% prior to the TCJA.

While the TCJA made the corporate tax rate cut permanent, the individual rate cuts are set to expire in 2025. However, future tax legislation could potentially alter the corporate tax rate.

In addition to rate reductions, the TCJA introduced several other changes. A notable provision for small business owners is the Section 199A qualified business income (QBI) deduction, which allows a deduction of up to 20% of QBI from noncorporate entities. The expiration of this deduction is a significant concern.

Another provision subject to expiration is the gradual phaseout of first-year bonus depreciation. The TCJA initially provided 100% bonus depreciation for qualified new and used property placed in service in 2022. This benefit is set to decrease to 80% in 2023, 60% in 2024, 40% in 2025, 20% in 2026, and phase out completely by 2027.

Potential Outcomes

The results of the upcoming presidential election and the composition of Congress will influence the future of the TCJA provisions. Four potential scenarios include:

• All TCJA provisions scheduled to expire will indeed expire at the end of 2025.
• All TCJA provisions scheduled to expire will be extended beyond 2025 or made permanent.
• Some TCJA provisions will expire while others are extended or made permanent.
• Some or all TCJA provisions will expire, with new laws enacted that introduce different tax benefits or rates.

The impact on your tax situation in 2026 will depend on which scenario unfolds, as well as the effects of the TCJA on your tax bill when it was first implemented. Factors influencing this include your business income, filing status, state of residence (with the SALT limitation affecting certain states), and the presence of dependents.

Additionally, the outcome of the presidential election and congressional control will play a crucial role, given the differing approaches of Democrats and Republicans. Tax proposals must pass both houses of Congress and be signed by the President to become law, or secure enough votes to override a presidential veto.

Looking Ahead

As the expiration of TCJA provisions approaches and election outcomes become clear, it is important to stay informed about potential changes and strategize accordingly. We are available to address any questions you may have and will continue to provide updates on the latest developments.

Let’s say you own highly appreciated land that’s now ripe for development. If you subdivide it, develop the resulting parcels and sell them off for a hefty profit, it could trigger a large tax bill.

In this scenario, the tax rules generally treat you as a real estate dealer. That means your entire profit — including the portion from pre-development appreciation in the value of the land — will be treated as high-taxed ordinary income subject to a federal rate of up to 37%. You may also owe the 3.8% net investment income tax (NIIT) for a combined federal rate of up to 40.8%. And you may owe state income tax too.

It would be better if you could arrange to pay lower long-term capital gain (LTCG) tax rates on at least part of the profit. The current maximum federal income tax rate on LTCGs is 20% or 23.8% if you owe the NIIT.

Potential tax-saving solution

Thankfully, there’s a strategy that allows favorable LTCG tax treatment for all pre-development appreciation in the land value. You must have held the land for more than one year for investment (as opposed to holding it as a real estate dealer).

The portion of your profit attributable to subsequent subdividing, development and marketing activities will still be considered high-taxed ordinary income, because you’ll be considered a real estate dealer for that part of the process.

But if you can manage to pay a 20% or 23.8% federal income tax rate on a big chunk of your profit (the pre-development appreciation part), that’s something to celebrate.

Three-step strategy

Here’s the three-step strategy that could result in paying a smaller tax bill on your real estate development profits.

1. Establish an S corporation 

If you individually own the appreciated land, you can establish an S corporation owned solely by you to function as the developer. If you own the land via a partnership, or via an LLC treated as a partnership for federal tax purposes, you and the other partners (LLC members) can form the S corp and receive corporate stock in proportion to your percentage partnership (LLC) interests.

2. Sell the land to the S corp

Sell the appreciated land to the S corp for a price equal to the land’s pre-development fair market value. If necessary, you can arrange a sale that involves only a little cash and a big installment note the S corp owes you. The business will pay off the note with cash generated by selling off parcels after development. The sale to the S corp will trigger a LTCG eligible for the 20% or 23.8% rate as long as you held the land for investment and owned it for over one year.

3. Develop the property and sell it off

The S corp will subdivide and develop the property, market it and sell it off. The profit from these activities will be higher-taxed ordinary income passed through to you as an S corp shareholder. If the profit is big, you’ll probably pay the maximum 37% federal rate (or 40.8% percent with the NIIT. However, the average tax rate on your total profit will be much lower, because a big part will be lower-taxed LTCG from pre-development appreciation.

Favorable treatment

Thanks to the tax treatment created by this S corp developer strategy, you can lock in favorable treatment for the land’s pre-development appreciation. That’s a huge tax-saving advantage if the land has gone up in value. Consult with us if you have questions or want more information.

© 2023