Smart Biz

Selling home The Part of Tens

Taxable profits on the sale of an investment property often are much greater than on a comparable residential property. The difference is that the IRS allows you to depreciate investment property while you own it and deduct the depreciation amount from your income taxes every year. The tax break is nice, but the IRS always is careful not to give people too much of a good thing. Therefore, when you sell the property, you must factor the depreciation you took on the property into the property's adjusted cost basis.

Suppose that you buy an investment property for $200,000, and many years later you sell it for $350,000. During your years of owning the property, you claim a total of $50,000 in depreciation on your tax returns. The amount of depreciation reduces your cost basis from the original $200,000 purchase price to $150,000, thus making your 'taxable profit' that much larger. You owe capital gains tax on $200,000 - the difference between the sale price of $350,000 and the adjusted cost basis of $150,000.

Fortunately, you can defer taxes on these gains by rolling over your profits into another investment property. If you simultaneously sell an investment property and buy another, that one exchange is called a 1031 exchange (1031 refers to the section of the tax laws that allows these exchanges). If the exchange isn't simultaneous - that is, if you delay your purchase of the second property - you must meet some specific requirements (called the Starker rules, after a famous tax case).

If you're going to do a Starker or a 1031 exchange, be sure to enlist the help of an attorney or tax advisor who's an expert at these transactions to ensure that you do it right. You need an experienced professional to help you jump the many legal hoops (such as filling out special tax forms like Form 8824, which tells the IRS that you bought a 'like kind' investment property).