Gain on rental real estate

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Dear Tax Talk,
I bought a home in 1989 for $50,000 as our primary home for a year. Then it became a rental when my husband was transferred due to military.

In May 2007 the city condemned the place because my tenants had destroyed it so badly. We began fixing it back up, but in October 2007 the city informed us they want to build a park there.

The place has been empty because of the condition. We had planned to fix it up and re-rent it.

We had already spent $30,000 in repairs by then. We took a home equity loan for $50,000 to afford it.

So we currently owe $45,000 on the mortgage and $50,000 on the equity. We are selling it to the city for $135,000. I have claimed depreciation on it since we originally bought it.

What will I have to pay in taxes on the gain? Any idea how I figure out how much I actually gained? How do I figure the depreciation? Is there any way to defer or avoid paying taxes at all? Can I reinvest this into my main residential home? Can I buy equipment for my business and not pay, or does that simply defer it? And for how long?

I hoped I could find some kind of loophole or tax law that would allow us to not pay. Does our income factor at all? We currently make about $90,000 before deductions.

Mary

Dear Mary,
You certainly fit a lot of questions into your e-mail. Your cost of the property is what you paid for it ($50,000) plus your improvements ($30,000). The borrowing in excess of improvements does not affect your cost.

Depreciation should have been computed during the rental period; this affects the cost of the property. See my previous article on depreciation for more information. If your depreciation should have been $20,000, your gain is $135,000, less your adjusted basis of $60,000 or $75,000 in gain, of which $20,000 is depreciation recapture.

When property is condemned or taken under eminent domain, we tax people call that an involuntary conversion. In other words, the property was converted into cash without any action on your part. You can postpone reporting gain from a condemnation if you buy replacement property.

Your replacement property must be similar or related in service or use to the property it replaces. Because the condemned property is rental real estate, your replacement property must be real estate held for investment.

Property is similar if it would qualify under the like-kind exchange rules. You can exchange for improved or unimproved property, but tools used in your business or improvements made to your home would not be considered replacement property. You can buy more than one replacement property.

After the mortgages are satisfied, you will walk away with $40,000 in cash but $75,000 in gain. However, you’re treated as realizing $135,000 — the selling price of the condemned property.

If you want to defer all the gain, you’ll need to buy at least $135,000 worth of property. The deferral also includes the deferral of the depreciation recapture. The deferral of gain continues until you sell your replacement property.

To postpone reporting your gain from a condemnation, you must buy replacement property within a certain period of time. This is the replacement period. The replacement period generally ends two years after the end of the first tax year in which any part of the gain on the condemnation is realized. If you transfer the property in 2008, your replacement property must be received by the end of 2010.

To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Taxpayers should seek professional advice based on their particular circumstances.

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