The Hidden Math Behind Selling Your Property

     When people sell their home, they often assume their profit is the difference between what they owe on the property and what they sell it for. Profit on a home sale is actually calculated as the selling price minus your adjusted basis (i.e., original purchase price plus improvements, minus depreciation)—not your loan balance. That profit is called capital gains and this is what you are taxed on. What you owe the bank has nothing to do with what you owe Uncle Sam.

     People can be in for a rude awakening if they don’t understand capital gains. If you are selling your primary residence, the IRS allows you to exclude up to $250,000 of capital gains from your taxable income if you’re an individual, or up to $500,000 if you're married and filing jointly. To qualify, you generally need to have owned and lived in the home as your primary residence for at least two of the last five years preceding the sale. If you are selling an investment property, there are no such exclusions.

     Let me walk you through a real-world example. Say you bought an investment property years ago for $250,000. Over time, you maintained it with fresh paint, landscaping, and routine repairs. You didn’t do any major work, so the tax basis didn’t do up because of improvements. Over that same time, there was a favorable housing market and the property appreciated in value. Now it's worth $550,000. You refinanced along the way and currently owe $440,000.

     You’re able to sell for $550,000. You net about $515,000 after sales costs, pay off the loan, and walk away with $65,000 in your pocket. Not bad, right? Except you forgot to figure in the capital gains tax. The capital gain is $265,000: the difference between your original basis and the sale price. And since this is an investment property, the personal residence exclusion doesn't apply. At a combined state and federal capital gains tax rate of around 35%, you're looking at roughly $92,750 in taxes. Suddenly, instead of a $65,000 payday, you’re in the hole $27,750 plus any recapture tax based on any depreciation taken.

     Here’s another example. Let’s say you purchased an investment property in 1973 for $18,000, with $3,000 down. You maintained the property but did not invest in any capital improvements. You refinanced multiple times, using the equity in the house to pull out $300,000 in total. Today, the loan balance sits around $203,500. If you sold at the property’s current market value of $400,000, net proceeds after sales costs would be around $375,000. After paying off the mortgage, you’d walk away with about $171,500, but the capital gain is $370,000, because fifty years of depreciation has reduced the basis down to essentially just the land value of $5,000. The resulting tax bill is roughly $129,500, leaving a net of only $41,500.

     Initially, you might be frustrated that the government gets such a big chunk of the profit—I understand your feelings. However, that $41,500 represents a return of just under 5.5% annually after taxes on a $3,000 initial investment, and that figure doesn't include the positive cash flow and cash-out refinance proceeds received along the way, which were substantial.

     This brings me to an important distinction that separates smart landlords from frustrated ones: the difference between repairs and capital improvements, and when each strategy makes sense. On a rental property, you generally want to repair rather than replace whenever possible. Repairs are immediately tax deductible against ordinary income, which is valuable right now. Capital improvements, like a full roof replacement, only reduce your capital gain rate when you eventually sell. On the other hand, for a primary residence or a property you plan to sell, you want to replace rather than repair. That new roof becomes a capital improvement that increases your basis and reduces your taxable gain at sale.

     The long-term picture for real estate remains compelling. Real estate has historically been one of the most reliable stores of value available to ordinary investors. A quality property purchased in today's market and held for decades is likely to produce a significant financial return, especially when you factor in cash flow, refinancing opportunities, and equity growth.

     Be aware, if you bequeath the real estate to your heirs after you pass away, they get a stepped up basis to fair market value at the date of your death and therefore would owe no capital gains taxes if they sell the property immediately.

     Just make sure you understand the math around capital gains before you sell.

     If you have questions about property management or real estate, please contact me at [email protected] or call (707) 462-4000. If you have an idea for a future column, share it with me and if I use it, I’ll send you a $25 gift certificate to Schat’s Bakery.

Dick Selzer is a real estate broker who has been in the business for more than 50 years. The opinions expressed here are his and do not necessarily represent his affiliated organizations.