Federal income tax for owners and investors
Agents are not tax advisers, and they should send clients to a CPA or tax attorney for advice. But the exam expects you to know the basic federal rules that drive buyers' and sellers' decisions.
Basis, adjusted basis and gain
- Basis generally starts with what the owner paid for the property, including certain closing costs (IRS Pub. 523).
- Adjusted basis is basis plus capital improvements (a new roof, an addition, a pool) and minus items such as depreciation taken on rental property (26 U.S.C. 1016(a)(1), (2)). Ordinary repairs and maintenance, such as fixing a leak or painting a room, do not add to basis.
- Amount realized is the selling price minus selling expenses such as commission (Pub. 523).
- Gain is amount realized minus adjusted basis. If adjusted basis is larger, the result is a loss (26 U.S.C. 1001(a)).
Worked example
An owner bought a home for $240,000 and paid $4,000 of closing costs that are added to basis. Later she added a $30,000 pool and spent $2,000 on repairs. She sells for $410,000 and pays $24,600 in commission and other selling costs.
- Adjusted basis: $240,000 + $4,000 + $30,000 = $274,000 (repairs are left out)
- Amount realized: $410,000 − $24,600 = $385,400
- Gain: $385,400 − $274,000 = $111,400
The home sale exclusion (Section 121)
A homeowner may exclude gain on the sale of a principal residence if, during the 5 years before the sale, the owner owned it and used it as a principal residence for periods adding up to at least 2 years (26 U.S.C. 121(a)). The two years do not have to be continuous (Pub. 523).
| Filing status | Maximum exclusion |
|---|---|
| Single | $250,000 (121(b)(1)) |
| Married filing jointly | $500,000 if either spouse meets the ownership test, both meet the use test, and neither used the exclusion in the past 2 years (121(b)(2)) |
The exclusion generally can be used only once every 2 years (121(b)(3)). Gain equal to depreciation taken after May 6, 1997 (for example, on a home office or a period of rental use) is not excluded (121(d)(6)).
Example: a married couple filing jointly has a $620,000 gain and meets every test. They exclude $500,000 and report $120,000.
Deductions for homeowners
Two homeowner costs can reduce federal income tax, but only for owners who itemize deductions on Schedule A:
- Mortgage interest on a loan secured by a main home or second home, subject to loan-amount limits (IRS Tax Topic 505).
- State and local real property taxes, subject to an overall cap on state and local tax deductions (IRS Tax Topic 503).
The dollar limits have changed several times in recent years, so the exam focuses on the concept: interest and property taxes are deductible for itemizers; principal payments, homeowners insurance premiums and HOA fees on a personal residence are not (IRS Pub. 530).
Depreciation for investors
Investors can deduct the cost of a building's wear and tear over its recovery period using the straight-line method (26 U.S.C. 168(b)(3), (c)):
| Property | Recovery period |
|---|---|
| Residential rental property | 27.5 years |
| Nonresidential real property (office, retail, warehouse) | 39 years |
Land is never depreciated because it does not wear out (IRS Pub. 527). Subtract the land value first.
Annual depreciation = (cost − land value) ÷ recovery period
A rental house bought for $385,000 with $55,000 allocated to land: ($385,000 − $55,000) ÷ 27.5 = $12,000 a year. Each year's depreciation lowers the adjusted basis, which increases the gain when the property is sold. Real property also uses a mid-month convention in the first and last year (168(d)(2)); exam problems usually ignore it unless they say otherwise.
Property used solely for personal purposes, such as the owner's own home, cannot be depreciated (IRS Pub. 946).
Like-kind (1031) exchanges
Section 1031 lets an investor defer gain by exchanging real property held for business or investment for other like-kind real property held for business or investment (26 U.S.C. 1031(a)(1)).
- Since January 1, 2018 (the Tax Cuts and Jobs Act), only real property qualifies. Equipment, vehicles and other personal property generally no longer do (IRS, "Like-kind exchanges now limited to real property").
- Property held primarily for sale, such as a flipper's inventory, does not qualify (1031(a)(2)). A personal residence does not qualify either, because it is not held for business or investment use.
- 45 days: the replacement property must be identified within 45 days after the old property is transferred.
- 180 days: the replacement must be received within 180 days, or by the due date (with extensions) of the tax return for that year, whichever is earlier (1031(a)(3)).
- Boot: cash or other non-like-kind property received is taxed, up to the amount of the gain (1031(b)). Receiving $30,000 cash in an exchange with a $90,000 gain means $30,000 is recognized now and $60,000 is deferred.
Deferred is not forgiven. The replacement property generally takes the old property's basis, adjusted for any boot and recognized gain (1031(d)), so the untaxed gain is built into it and can be taxed when that property is sold.