TAXING TIMES, OCTOBER 2014 EDITION
By Rick Torkelson, CPA and principal of Torkelson & Associates, LLP in Petaluma, CA
Last month I discussed the effects on your tax return if you purchase and rent a residential rental. In my example, we purchased a house for $400,000. We put $100,000 down and financed $300,000 at 5% for 30 years. Our rent income and our payments for interest, principal, insurance, etc broke even. Depreciation gave us a tax loss of $6,500 every year saving us about $2,230 in income taxes year after year depending on your tax bracket.
If all went according to plan, our rental house is worth more now than when we bought it. Let’s assume that we have owned this rental for 10 years and that it is now worth $550,000 and we will assume that we sell the property for $550,000.
Our first step is to compute the gain. The gain is computed by subtracting the basis of the property from the net sales price. The net sales price would be $550,000 less any costs of sale. Let’s assume the only selling costs was a 5% commission or $27,500. Net Sales price is $522,500.
Basis is the cost of the property less any depreciation. As I discussed last month – depreciation each year would be about $11,000 – computed by dividing the cost of the rental (not the land) by 27½ years. In 10 years, that would be total depreciation of $110,000. From here the basis is $290,000 (cost of $400,000 less depreciation of $110,000). This leaves a total gain of $232,500 ($522,500 net sales less $290,000 basis).
The good news is that this $232,500 is all long term capital gain. Long term capital gain is taxed generally at 15% Federal and whatever your California rate is – I’m assuming 9.3%. Assuming an overall rate of 24.3%, the tax cost of this gain would be $56,500 (24.3% of $232,500).
Let’s take a moment to add up what happened here. We put down $100,000 and financed $300,000. We made payments on the $300,000 for 10 years. After 10 years of payments, the balance of this loan would be about $244,000. We wrote off $11,000 of depreciation every year for 10 years saving us about $22,300 in taxes over those 10 years. We sold the property after 10 years for $550,000 paying $27,500 to sell it. Income taxes on our gain was $56,500.
Down Payment <$100,000.>
Tax Savings as a rental: 22,300.
Sales Price: 550,000.
Pay-off Loan: <244,000>.
Income Tax: <56,500>.
Net Profit after tax: $144,300.
I know this is over simplified, but I kept the number fairly typical. Next month I’ll write about two common tricks to defer tax on the sale – Installment sale and Tax deferred exchanges.
2013 Individual income tax returns are due October 15th if you extended. File timely! If you owe money and miss the October 15th deadline, late filing penalties are 5% per month from April 15, 2014 – that’s 30% on top of the money you owe one day after October 15th.
Do your tax planning soon. If you’ve had an unusual year, the best way to avoid surprises is to project your taxes now – when there’s time to do something about them.