Top Tax-Time Tips
From a Property Pro

Question: I own a rental property and was told several years ago that depreciation I take now will be taxed at 25% when I sell the property, rather than the lower 20% capital-gains tax rate. Is this still the case despite all of the recent tax-law changes?

-- Dan, Wilmington, N.C.

Dan: You can depreciate your residential rental property for 27 1/2 years, but there's a piper to be paid when you sell. The Tax Act of 1997 reduced the federal capital-gains tax to 20%, provided you own the property for at least 12 months. But when you depreciate your real estate, a special tax rate applies -- but only to the portion you've depreciated. Upon sale, the amount you depreciated is "recaptured" at a higher 25% rate.

Perhaps an example will help. An investor buys a rental property for $150,000 and depreciates it (the improvements, not the land) for four years, for a total of $12,000. At the end of the fourth year, he sells the house for $200,000. His adjusted cost basis for the property is the original $150,000 less the $12,000 in depreciation, or $138,000. The capital gain is the difference between this amount and the net sale price, or $62,000. This amount will be taxed at the 20% rate except for the portion that he depreciated ($12,000), which is taxed at the higher 25% rate. Check with your accountant or tax adviser to ensure that this typical situation applies in your case, too.

This Exclusion Can Save You Some Money

Question: I recently sold my home and made a substantial profit. I've heard that I may be able to avoid paying taxes on the gain, but I'm not sure I qualify. What are the rules governing the exclusion?

-- Stanley, Las Cruces, N.M.

Stanley: Single homeowners can exclude gains of as much as $250,000 from the sale of their primary residence and married taxpayers who file jointly can exclude up to $500,000. To qualify for the exclusion, you'll need to satisfy the Internal Revenue Service's ownership and use tests. This means that you must have owned your home for two years and lived in it as your main home for at least two years during the five-year period ending on the date of sale. If you can't meet these tests, you might still be eligible in some cases to claim a reduced exclusion. See IRS Publication 523 for more details.

Real-Estate Losses Won't Help You Limit Your Tax Bill

Question: Last year, I sold a second-home condo in New Hampshire, which I shared with three other owners, at a loss. Though we considered the unit an investment, it wasn't rented during the 20 years we owned it, and we used it mostly for recreational purposes. Is there any way to show this loss on Form 1040 when I file my income-tax return?

-- Michael, Killington, Vt.

Michael: Unfortunately, losses on a personal residence -- whether the property was your principal residence or just a vacation home -- can't be taken as a deduction when filing your federal income-tax return.

Why Complicated Tax Solutions Aren't Worth the Trouble

Question: I found a house I'd like to buy, but the list price is a little bit more than I can afford. The seller is willing to consider an owner-financed deal at a lower price if such an arrangement will lighten his tax burden. Are there any attractive scenarios I can present to him? Would making payments to his child's college fund or trust provide any tax benefits?

-- Elena, Brooklyn, N.Y.

Elena: By selling over time using the installment method, the owner would essentially pay taxes as the money is received. In today's environment, such an arrangement offers few advantages. But this procedure is fairly complicated, so he'll need to check with an accountant to be certain that his situation isn't atypical.

Regarding your hope that you can minimize the seller's tax burden by making payments to his children (or their college fund), most of these loopholes have been closed. In any event, the manipulations of the purchase agreement that you'd have to make to pull this off would undoubtedly set off a host of red flags that could get you into trouble. As Robert Frost said, "Sometimes the best way around a problem is through it." Instead of trying elaborate tax gimmicks, why not offer the seller a more attractive interest rate on a carry-back mortgage? Though this will increase your monthly payments a bit, it could please him so much he'll consider a lower price.

-- Mr. Irwin has more than 25 years' experience as a Los Angeles-area real-estate broker. He is the author of more than two dozen books about real estate and is recognized as one of the most knowledgeable writers in the real-estate field. Mr. Irwin's most recent book is "Tips and Traps When Renovating Your Home," (McGraw-Hill, 2000).

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