ROBERT L. SOMMERS
Note: This exercise is for educational purposes only and is not intended to be legal or tax advice. Your particular facts and circumstances must be considered when applying the U.S. tax law. You should always consult with a competent tax professional with respect to your particular situation.
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Question: I recently sold a vacation home. I thought my tax gain would be the difference between my purchase price and the sales price, but the actual tax was much higher. Why? [Answer]
Question: I sold my rental property for a large gain. May I return the money to the escrow company and treat the transaction as part of a tax-free exchange? [Answer]
Question: My landlord paid me $10,000 to cancel my apartment lease. Is this amount taxable to me? [Answer]
Answer: Gain or loss on the sale of an asset is measured by the amount realized (usually the amount you receive) minus your adjusted basis (the tax cost of your property, with adjustments).
Start with the basis of the property when you acquired it. If you bought it, then your adjusted basis is the purchase price. Property received by gift receives a carry-over basis (the donors basis becomes yours). Property received in a tax-free exchange receives a substituted basis (the basis in your old property becomes the basis in the new one).
Once you establish your initial basis, improvements to the property increase you basis, but depreciation deductions (whether or not you claim them!) reduce it. In your case, the disparity between the amount realized and your adjusted basis caused a larger gain than you anticipated. This probably occurred because you failed to reduce your adjusted basis by the depreciation deductions. To avoid future surprises, have your accountant calculate your potential gain from the sale of property, prior to selling it.
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Answer: No. Once you receive the money, its too late. Section 1031 requires an intent to exchange one property for another (called contractual interdependence); also, the taxpayer cannot receive sales proceeds.
Unfortunately, taxpayers might "constructively" receive cash, thereby destroying their chances for a successful tax-free exchange. You constructively receive cash when you have the right to obtain the cash (or the benefit of the cash) without substantial restrictions. For instance, money left in escrow, but available to you, constitutes constructive receipt. The same is true if a check is issued, but you decide not to cash it.
Under Section 1031, your must exchange property held for investment or in a trade or business for like-kind property which will be held for investment or in a trade or business. The like-kind requirement is liberally interpreted for real estate transactions: raw land is like kind to a condominium apartment, a lease of real estate for 30 years or longer is like-kind to outright ownership.
Section 1031 does not apply to personal residences because it is considered personal property, rather than investment property.
Section 1031 allows for a deferred exchange (you transfer your property first and then later receive replacement property). These exchanges are often complicated and have strict deadlines. You only have 45 days from the close of escrow to identify replacement property. And completion of the exchange must occur with 180 days from the close of escrow (or if the exchange occurs late in the tax year, the due date for your tax return, plus extensions).
Because of constructive receipt concerns, usually a neutral and independent intermediary is necessary to hold the proceeds while the exchange is being completed.
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Answer: Yes, the amount you received is in exchange for your lease rights. This rule applies whether the lease is for real estate or personal property. A cancellation is a termination of your contractual rights, prior to the expiration date. Usually, the amount received is taxed as a capital gain.
If, however, a landlord receives a lump-sum payment from a tenant for cancellation of a lease, the amount received is taxed as ordinary income; it is not a capital gain.
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**NOTE: The information contained at this site is for educational purposes only and is not intended for any particular person or circumstance. A competent tax professional should always be consulted before utilizing any of the information contained at this site.**