Navigating Tax Implications on Real Estate Gains

When you sell real estate that has been held for more than one year, resulting in a taxable gain, the tax implications can vary depending on the nature of the property and how it was held. Whether the property is owned directly or indirectly through a pass-through entity such as an LLC, partnership, or S corporation, it’s common to expect to pay the standard federal income tax rate of 15% or 20% on long-term capital gains. However, certain real estate gains may be subject to higher tax rates due to depreciation deductions. Below is an overview of the federal income tax issues that may apply to real estate gains.

Vacant Land

The maximum federal long-term capital gains tax rate for the sale of vacant land is currently 20%. This rate applies to individuals with high incomes. For single filers in 2024, the 20% rate applies when taxable income, including any gain from the sale of land and other long-term capital gains, exceeds $518,900. For married couples filing jointly, the threshold is $583,750, and for heads of households, it is $551,350. If your income is below these thresholds, the maximum federal tax rate on a land sale gain is 15%. Additionally, you may owe the 3.8% Net Investment Income Tax (NIIT) on some or all of the gain.

Gains Attributable to Depreciation

Gains that result from depreciation deductions on real estate, calculated using the straight-line method, are referred to as "unrecaptured Section 1250 gain." This type of gain is generally taxed at a flat 25% federal rate, unless the gain would be taxed at a lower rate if treated as regular taxable income. You may also be liable for the 3.8% NIIT on some or all of the unrecaptured Section 1250 gain.

Gains from Depreciable Qualified Improvement Property

Qualified Improvement Property (QIP) includes any improvement to the interior of a nonresidential building that is placed in service after the building's initial service date. However, it excludes expenditures for enlarging the building, elevators, escalators, or the building's structural framework.

If you claim first-year Section 179 deductions or first-year bonus depreciation for QIP, any gain from the sale of this property, up to the amount of the Section 179 deductions, will be classified as Section 1245 ordinary income recapture. This means the gain will be taxed at your regular income tax rate rather than the lower long-term capital gain rates. Additionally, the 3.8% NIIT may apply to some or all of this recapture gain.

For QIP with first-year bonus depreciation, any gain up to the excess of the bonus depreciation deduction over the straight-line depreciation will also be classified as Section 1250 ordinary income recapture. This gain is taxed at your regular rate, and you may owe the 3.8% NIIT on some or all of the recapture gain.

Tax Planning Consideration:  If you choose to use the straight-line depreciation method for real property, including QIP, without claiming first-year Section 179 or bonus depreciation deductions, you can avoid Section 1245 or Section 1250 ordinary income recapture. Instead, you will only have unrecaptured Section 1250 gain, which is taxed at a federal rate of no more than 25%. However, the 3.8% NIIT may still apply to some or all of the gain.

Conclusion

As illustrated, the federal income tax rules for real estate gains can be complex, with varying tax rates depending on the type of gain. Additionally, the 3.8% NIIT and state income taxes may also apply. We are here to manage the complexities when preparing your tax return. Please contact us with any questions regarding your specific situation.