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Calculating correct capital gains

George SaenzDear Tax Talk,
I read your "Do I owe capital gains and if so, how can I reduce them?" with interest as I finally sold my rental property in central New York. It was straight-line depreciated since 1980 for 20 years. I bought it for $27,000 and sold it for $40,000.

Which leads me to a grave error when thinking about putting enough income tax aside. If I pay a 20 percent capital gains tax on $40,000, that should be a maximum $8,000 of gain. Why then was approximately $32,000 added to my income vs. the $8,000 of capital gains. It looks as if the capital gains was scrapped and I wound up with a big increase in ordinary income. Thanks! -- Roy

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Dear Roy,
Grave errors are reserved for life and death decisions. Paying taxes doesn't quite cut it.

If you bought the property for $27,000 and depreciated $20,000, then you have $20,000 in depreciation recapture (this calculation assumes the amount you originally allocated to land is $7,000).

Of your total gain of $32,000, not counting $1,000 for closing costs, you have two components: $20,000 referred to as unrecaptured Section 1250 gain and $12,000 in long-term capital gain, both of which are collectively referred to as Section 1231 gain.

The sale of the property is reported on page 2 of Form 4797. All $32,000 in gain flows through to Schedule D and winds up in full on page 1 of your 1040. Hence, you get the feeling that you're paying ordinary income tax on the gain. But this is not the case when you go to figure the tax due (line 41 of your individual return) on your taxable income.

To figure this tax and get the special capital gains rates you have to use special worksheets included with Schedule D. Let me caution you these worksheets should not be completed without the use of tax software.

Let's say your taxable income is $82,000, including the Section 1231 gain of $32,000. When you complete the special worksheets, you'll compute the ordinary tax on $50,000, the rate applicable to depreciation recapture is 25 percent and the 20 percent rate applies to the remaining $12,000 in gain. Your total tax on the property sale is $7,400, which is 25 percent of $20,000 or $5,000 plus 20 percent of the remaining $12,000 or $2,400.

A copy of a properly completed Schedule D Worksheet D-7 is attached in Adobe format.

 
-- Posted: May 6, 2003
   

 

 
 

 

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