When considering what to do with rental property in a divorce, common options are to sell it or award it to one spouse (probably in exchange for other assets). Sometimes one of the spouses will move into it. Rental property sales value can be key in making these decisions.
You should always find out the current market value of the property, the total outstanding balance of all loans against the property, the monthly costs of ownership and the current rental income.
Especially if there is any likelihood the property will be sold before long, it’s also important to understand the likely net sale proceeds. Here it’s common to overlook two things affecting rental property sales value: selling costs and taxes.
Selling costs are easy: a common yardstick is they will cost you about 7% of the market value of the property. Most of this will go in real estate commissions.
Figuring out the tax bill is more complicated. Here’s the basic formula the IRS uses to figure out how much you would make on a sale:
Gain = sales price – selling costs – purchase price – improvements – purchase costs + depreciation.
To clarify some of these, the “purchase price” is what you paid for the property. “Improvements” is the cost of long-lasting improvements you may have made (new furnace or bathroom; not new carpet or painting). “Purchase costs” are any monies you had to pay at the time of purchase to buy the property (not counting loan down payments).
Depreciation is often missed. The IRS requires you to depreciate rental property over 27.5 years on a straight line basis. That means if you bought a rental property for $275,000, the IRS expects you to depreciate it $10,000 per year for 27.5 years. You get to claim this “depreciation expense” each year on your tax return (and this reduces your tax bill). But when the property is sold, the IRS wants tax for the depreciation – whether or not you’ve been remembering to claim it as an expense.
Let’s say you bought a rental property ten years ago for $275,000. You had purchase costs of $5,000. Since then you’ve spent $20,000 making improvements. The depreciation has been $10,000 per year for ten years or $100,000 in total. You think you can sell the property for $500,000 with selling costs of $35,000. The outstanding balance on your mortgage is $350,000 because you refinanced several years ago.
The IRS would figure your “gain” on the sale to be $500,000 – $35,000 – $275,000 – $20,000 – $5,000 + $100,000 = $265,000. $165,000 of this would be considered a “long-term capital gain” and $100,000 would be “depreciation recapture.”
Most taxpayers will have a tax rate of 15% on long-term capital gains and 25% on depreciation recapture. 15% of $165,000 plus 25% of $100,000 = $49,750 tax due to the IRS.
California taxes long-term capital gains and depreciation recapture just like regular income. Assuming a 9% tax rate on the gain of $265,000 gives = $23,850 in tax due to California.
Rental Property Sales Value
Notice that the outstanding mortgage balance on the property has no bearing when figuring out the taxes due on the sale.
Back to our example, an overly-simplistic view is that the property is worth $150,000 ($500,000 minus the $350,000 mortgage balance). But what if you actually sold the property? If you sold it for $500,000, paid off the $350,000 mortgage, paid selling expenses of $35,000, paid the IRS $49,750 and paid California $23,850, you’d be left with only $41,400 – much less than you might expect
The purpose of this article is to help you understand factors affecting rental property sales value in your divorce settlement. You may want to consult with a Certified Divorce Financial Analyst or tax specialist on your particular situation.