Tax question on a home sale - ordinary income vs capital gains

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What specifically is preventing it from being classified as capital gains

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I think you're asking about the tax exemption for primary residences, and to get that you need it to be your primary residence for like 2 or either 4 or 5 years or some shite. If you were renting it out, then it couldn't be your primary residence.

Did you claim property depreciation on the rental home?

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When you claim property depreciation on your tax return for your current investment property, it reduces your annual income that would be subject to taxes. Then, when you sell the property, the IRS wants that money back. Therefore, when the sale price of a property exceeds the tax basis or adjusted cost basis, the difference is “recaptured” by reporting it as income that’s then taxed using ordinary income tax rates.

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LINK

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Were you reporting the rental income on Schedule E of your 1040? Or just pocketing the rent?

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I reported it all rental income accurately and took depreciation deduction during the years was rented

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Basis of home at time of sale: 200K - 30K = $170K
Net proceeds - $250K - $15K - $235K

Gain: $235K - $170K - $65K

Ordinary gain: $30K

LTCG: $65K - $30K = $35K

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appreciate you breaking it down, but why do you subtract 30K twice? Its subtracted at basis of home sale and then again at LTCG?

what am i missing?

never fully understood depreciation and recapture, but this certainly helps

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Actually looks like it makes sense now. My error was not knowing that capital gains impact Modified Adjusted Gross Income. That is why I was thinking the entire gain was being treated as ordinary income

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Yeah, it does. Soemtimes I wish the 1040 would show ordinary tax vs capital gains tax right on the face, instead of in the worksheets. So many times clients have asked me... "but how do I know what the tax was on capital gains vs ordinary income", and I have to send them to the worksheets.

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Kind of dumb that capital gains prevent you from deducting from childcare and preschool expenses since it's not like I'll be able to replicate this annually, this was a one time benefit I got super lucky on

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Yes, but the idea is that yuu don't need those benefits THIS YEAR. But you can get the back next year if your income drops back to a level that qualifies.

Now, imagine this. After many years of successful stock picking, you decide you no longer want to manage your investments and you move all your money over to a money manager and give them trade authority. They believe that your portfolio is way out of whack in terms of asset allocation, and so they start selling and buying like crazy. When they are done, they have realized 300K in capital gains.

Issue 1: Client now owes cap gains on 300K although they didn't take any money out of the market.

Issue 2: Clients are Medicare age. A lot of people might not realize this, but Medicare premiums are means tested... the more you earn... the higher the premium you pay. It's a two year trail... your 2022 income impacts your 2024 premiums. It resets every year.

So not only did this couple have to pay tax on $300K in capital gains on their 2022 taxes, they will have to pay several thousand dollars more of additional Medicare premium in 2024. All without withdrawing a single dollar from their investment account.

On Monday, I consulted with a client that had this exact situation.

It's only important if you are audited...

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On Monday, I consulted with a client that had this exact situation.

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I hate it for them and that puts it in perspective. Seeing that you're a real CPA, very much appreciate the time to answer my questions, especially given this time of year

Now I'm curious about this situation. It looks like their money manager should've done this reallocation more gradually over a 3 year period to soften the blow of the capital gains?

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Now I'm curious about this situation. It looks like their money manager should've done this reallocation more gradually over a 3 year period to soften the blow of the capital gains?

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At a minmimum, there should have been a clearer understanding that the advisor was going to do this, so the client can be prepared.

Ideally, yea, try to spread this over a few years.

Look... I get WHY the advisor did what he did. That's what he is paid to do. The client was very heavy in a bunch of old, low-basis stock.

The tax is important. But, more and more, we are having to do tax planning around both Medicare premium adjustments like this, but also Marketplace subsidies.

You are seeing a lot of people retire at 60, 61 etc without any retiree health insurance. Cobra sometimes is an option but hella expesnsive, and that runs out. So there are more and more people who are going on the marketplace for 2-3 years as a bridge to Medicare. Because the subsidies are income based, they are looking to keep their income down yet still have cash needs. It's causing hard looks at drawing down Roth balances and drawing down non-retirement assets, delaying social security benefits, etc until after they are on Medicare. Long term, those might not be the best options, but there is such a concern about those premiums.