Commercial Rental property gain

[KarenMM]

Hello All - Client's father rents out gas station. Until 2006, property only consisted of land, as lessee improved with gas station building, etc. In preparation for sale, father's lawyer told father to buy the building from the lessee, which happened in Jan 2006. Building was NOT depreciated in 2006 tax return. Property was sold in 2007. Not including capital gain, father's AGi will be about $29,200, including $10.4k social security, qualifying him for 5% capital gains rates.

Land basis was $63k; Building was bought in 2006 for $62k; property was sold for $450k and selling expenses were $56k, giving a capital gain of $269k.

Questions:
1. Even though this is commercial property gain, appearing on part 1 of the 4797, doesn't it qualify for the 5% gain treatment?
2. Since no depreciation was taken, do I have any depreciation recapture to worry about?
3. What are the AMT implications here?
4. Is there anything else I am not thinking about that impact the estimated tax payment that this guy needs to make?
THANKS for your help. K

[joanmcq]

Only part of the gain will be taxed at 5%; the amount between the $29,200 and the top of the 15% bracket. If he's single, it won't be much.

Why did his lawyer advise him to buy the building?

[Roland Slugg]

Dear KarenMM

I'll respond to all your questions. First, however, a comment about what you wrote about reporting the sale on F-4797 ....

To properly report this sale on the T/P's return, allocate the selling price between the land and the building. Do the same with the costs to sell. Then report everything as if it were two sales ... not one. The land was surely sold at a gain, and it should be reported on F-4797, Part I. Since the building wasn't owned very long, it may have been sold at a gain or a loss. Report the building sale on F-4797 as follows: (A) If held more than one year and sold at a gain -- Part III; (B) If held more than one year and sold at a loss -- Part I; or (C) If not held for more than one year -- Part II, whether sold at a gain or a loss.

Now to your actual questions:

1. Yes, but as mentioned by another only some of the LTCG will be taxed at 5%. The rest will be taxed at 15%.

2. If the building was "placed in service" by the seller for all or a portion of the time he owned it (January 2006 to some date in 2007), depreciation should have been taken for that period. If this is the case, an amended return should be filed for 2006 to claim that year's depreciation. Depreciation should also be taken on the T/P's 2007 return. If the sale of the building results in a gain, the 2006 and 2007 depreciation will be treated as Unrecaptured §1250 gain (but not more than the amount of gain itself), and taxed as ordinary income up to a maximum tax rate of 25%.

3. The AMT implications are that the gain may result in some AMT. The most likely way that could happen is if the AMTI is in the "phase-out" range. You may wish to estimate this in advance by doing a pro-forma return using your tax prep software.

4. For estimated taxes, be sure to advise the client to make a "safe" estimate for 2007. To do so he should pay, in equal or greater installments, the amount of his actual 2006 tax. If he had no tax liability (not balance due ... liability), there will be no underpayment penalty for 2007.

Related observations ....

This appears to have been a good situation for an installment sale. The tax rate for 2008 (as well as 2009 and 2010 if not repealed by Congress) will be 0% on LTCG that would have been taxed at the 5% rate in 2007.

On the other hand an installment sale may have resulted in up to 85% of the T/P's social security being taxed in each future year when installments are received. By reporting all the gain in 2007 the taxed social security is limited to just this one year. All-in-all that might be better than an installment sale.

[ED SMITH]

Catch-up Depreciation

I agree with Rolands assessment except for one thing.

There is no reason to file an amended return, because of depreciation, as this can be taken as catch-up depreciation on form 4562 (there is a line for prior years depreciation).

[Gretel]

That's news to me. Which line are you referring to?

[KarenMM]

Thanks!

You have confirmed how I thought this transaction should go (except I thought the gain may have been ALL at the 5% rate).... I will have the client break out land and building... and I will put last year's depreciation on this year's 4562. I don't know why lawyer wanted the building bought, except to provide a "cleaner" sale. (I think the sale was not made to the lessee, but to a third party.) The client will make the estimated tax payment by 12.31.07, and doesn't want to pay more than needed!

THANKS for your help.... I am mostly a lurker on this board, and have learned much here! Karen

[Davc]

That's news to me. Which line are you referring to?

I'm guessing it's a misinterpretation of line 17 which is for current year's depreciation on assets placed in service in prior years.

[solomon]

See Rev. Proc. 2007-16 for the appropriate way to handle the depreciation in the year of sale for depreciation that was not previously claimed.