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.
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