What Drives the Tax on a Real Estate Sale

Owners usually know the price. Fewer know the tax. The gap between the two comes down to a handful of numbers, and most of them are set long before the sale.

Gain starts with basis

Your gain is what you receive, minus your adjusted basis. What you receive includes the cash plus any debt you’re relieved of at closing, whether it’s paid off or taken over by the buyer. Adjusted basis is generally what you paid, plus improvements, minus depreciation.

That last part matters. Basis comes down by depreciation allowed or allowable: the depreciation you were entitled to take, whether or not you claimed it. A property owned for fifteen years can have a basis far below what the owner remembers paying.

Not all gain is taxed the same

Federally, gain on real estate held more than a year is usually split into layers:

• Gain from depreciation on the building (unrecaptured Section 1250 gain), taxed at up to 25%

• Gain on components treated as personal property, often identified in a cost segregation study, recaptured as ordinary income up to the depreciation taken

• The rest, generally taxed at long-term capital gain rates

• The 3.8% net investment income tax, which may apply on top

States add their own layer. Many, including California, tax capital gains at ordinary income rates, so the state piece can rival the federal one.

Asset sale or entity sale

If the property sits in an LLC or partnership, you may be able to sell the property itself or sell the ownership interests. The choice changes the buyer’s basis and what history the buyer inherits, and it changes the character of your gain:

Section 751. When you sell a partnership interest, part of the gain can be taxed as ordinary income to the extent it reflects “hot assets” inside the partnership, such as depreciation recapture on personal property components.

Section 1061. For federal purposes, if you’re a sponsor selling a promote or carried interest, gain on that interest generally needs a holding period of more than three years to be taxed as long-term capital gain.

Transfer and property taxes. Transfer taxes and California property tax reassessment also turn on how the deal is structured.

This is one of the more technical corners of real estate tax, and it’s worth deciding on purpose rather than by default.

Purchase price allocation

When you buy, the price is split between land, building, and other assets. Land isn’t depreciable, so that split sets your deductions for years. When you sell, it sets how much of your gain is recapture. Buyers and sellers often want different allocations, and agreeing on one in the contract helps keep both sides’ returns consistent.

Foreclosures and workouts

A foreclosure or deed in lieu is generally treated as a sale or exchange for tax purposes, even though nobody receives cash. With nonrecourse debt, the full loan balance generally counts as the amount realized. With recourse debt, the property’s value generally counts as the amount realized, and any forgiven balance above that can be cancellation of debt income, which has its own exclusions. Lenders taking property back have their own tax consequences.

What to look for in a tax advisor for a sale

Whoever you work with, look for someone who:

• Works in real estate as a core practice, not a side line

• Asks about basis, debt, entity structure, and your plans for the proceeds before talking about the return

• Puts recommendations and the assumptions behind them in writing

• Coordinates with your attorney, broker, lender, and intermediary

• Tells you plainly when a strategy doesn’t fit your situation

Before you list

Pull together three documents: the closing statement from your purchase, a record of improvements, and the depreciation schedule from your returns. They answer most of the questions above. If any are missing, rebuilding them before the sale is far easier than after.