Tax Briefs

Help ensure your partnership or LLC complies with tax law

When drafting partnership and LLC operating agreements, various tax issues must be addressed. This is also true of multi-member LLCs that are treated as partnerships for tax purposes. Here are some critical issues to include in your agreement so your business remains in compliance with federal tax law.

Identify and describe guaranteed payments to partners

For income tax purposes, a guaranteed payment is one made by a partnership that’s: 1) to the partner acting in the capacity of a partner, 2) in exchange for services performed for the partnership or for the use of capital by the partnership, and 3) not dependent on partnership income.

Because special income tax rules apply to guaranteed payments, they should be identified and described in a partnership agreement. For instance:

The partnership generally deducts guaranteed payments under its accounting method at the time they’re paid or accrued.
If an individual partner receives a guaranteed payment, it’s treated as ordinary income — currently subject to a maximum income tax rate of 37%. The recipient partner must recognize a guaranteed payment as income in the partner’s tax year that includes the end of the partnership tax year in which the partnership deducted the payment. This is true even if the partner doesn’t receive the payment until after the end of his or her tax year.

Account for the tax basis from partnership liabilities

Under the partnership income taxation regime, a partner receives additional tax basis in his or her partnership interest from that partner’s share of the entity’s liabilities. This is a significant tax advantage because it allows a partner to deduct passed-through losses in excess of the partner’s actual investment in the partnership interest (subject to various income tax limitations such as the passive loss rules).

Different rules apply to recourse and nonrecourse liabilities to determine a partner’s share of the entity’s liabilities. Provisions in the partnership agreement can affect the classification of partnership liabilities as recourse or nonrecourse. It’s important to take this fact into account when drafting a partnership agreement.

Clarify how payments to retired partners are classified

Special income tax rules also apply to payments made in liquidation of a retired partner’s interest in a partnership. This includes any partner who exited the partnership for any reason.

In general, payments made in exchange for the retired partner’s share of partnership property are treated as ordinary partnership distributions. To the extent these payments exceed the partner’s tax basis in the partnership interest, the excess triggers taxable gain for the recipient partner.

All other payments made in liquidating a retired partner’s interest are either: 1) guaranteed payments if the amounts don’t depend on partnership income, or 2) ordinary distributive shares of partnership income if the amounts do depend on partnership income. These payments are generally subject to self-employment tax.

The partnership agreement should clarify how payments to retired partners are classified so the proper tax rules can be applied by both the partnership and recipient retired partners.

Consider other partnership agreement provisions

Since your partnership may have multiple partners, various issues can come into play. You’ll need a carefully drafted partnership agreement to handle potential issues even if you don’t expect them to arise. For instance, you may want to include:

A partnership interest buy-sell agreement to cover partner exits.
A noncompete agreement.
How the partnership will handle the divorce, bankruptcy, or death of a partner. For instance, will the partnership buy out an interest that’s acquired by a partner’s ex-spouse in a divorce proceeding or inherited after a partner’s death? If so, how will the buyout payments be calculated and when will they be paid?

Minimize potential liabilities

Tax issues must be addressed when putting together a partnership deal. Contact us to be involved in the process.

6 tax-free income opportunities

Believe it or not, there are ways to collect tax-free income and gains. Here are some of the best opportunities to put money in your pocket without current federal income tax implications:

Roth IRAs offer tax-free income accumulation and withdrawals. Unlike withdrawals from traditional IRAs, qualified Roth IRA withdrawals are free from federal income tax. A qualified withdrawal is one that’s taken after you’ve reached age 59½ and had at least one Roth IRA open for over five years, or you are disabled or deceased. After your death, your heirs can take federal-income-tax-free qualified Roth IRA withdrawals, with proper planning.
A large amount of profit from a home sale is tax-free. In one of the best tax-saving deals, an unmarried seller of a principal residence can exclude (pay no federal income tax on) up to $250,000 of gain, and a married joint-filing couple can exclude up to $500,000. That can be a big tax-saver, but you generally must pass certain tests to qualify. For example, you must have owned the property for at least two years during the five-year period ending on the sale date. And you must have used the property as a principal residence for at least two years during the same five-year period. Note: To be eligible for the larger $500,000 joint-filer exclusion, at least one spouse must pass the ownership test and both spouses must pass the use test.
People with incomes below a certain amount can collect tax-free capital gains and dividends. The minimum federal income tax rate on long-term capital gains and qualified dividends is 0%. Surprisingly, you can have a pretty decent income and still be within the 0% bracket for long-term gains and dividends — based on your taxable income. Single taxpayers can have up to $47,025 in taxable income in 2024 and be in the 0% bracket. For married couples filing jointly, you can have up to $94,050 in taxable income in 2024.
Gifts and inheritances receive tax-free treatment. If you receive a gift or inheritance, the amount generally isn’t taxable. However, if you’re given or inherit property that later produces income such as interest, dividends, or rent, the income is taxable to you. (There also may be tax implications for an individual who gives a gift.) In addition, if you inherit a capital gain asset like stock or mutual fund shares or real estate, the federal income tax basis of the asset is stepped up to its fair market value as of the date of your benefactor’s demise, or six months after that date if the estate executor so chooses. So, if you sell the inherited asset, you won’t owe any federal capital gains tax except on appreciation that occurs after the applicable date.
Some small business stock gains are tax-free. A qualified small business corporation (QSBC) is a special category of corporation. Its stock can potentially qualify for federal-income-tax-free treatment when you sell for a gain after holding it for over five years. Ask us for details.
You can pocket tax-free income from college savings accounts. Section 529 college savings plan accounts allow earnings to accumulate free of any federal income tax. And when the account beneficiary (typically your child or grandchild) reaches college age, tax-free withdrawals can be taken to cover higher education expenses. Alternatively, you can contribute up to $2,000 annually to a Coverdell Education Savings Account (CESA) set up for a beneficiary who hasn’t reached age 18. CESA earnings are allowed to accumulate free from federal income tax. Then, tax-free withdrawals can be taken to pay for the beneficiary’s college tuition, fees, books, supplies, and room and board. The catch: Your right to make CESA contributions is phased out between modified adjusted gross incomes of $95,000 and $110,000, or between $190,000 and $220,000 if you’re a married joint filer.

Advance planning may lead to better results

You may be able to collect federal-income-tax-free income and gains in several different ways, including some that aren’t explained here. For example, proceeds from a life insurance policy paid to you because of an insured person’s death generally aren’t taxable. So, don’t assume you’ll always owe taxes on income. Also, check with us before making significant transactions because advance planning could result in tax-free income or gains that would otherwise be taxable.

It’s time for your small business to think about year-end tax planning

With Labor Day in the rearview mirror, it’s time to take proactive steps that may help lower your small business’s taxes for this year and next. The strategy of deferring income and accelerating deductions to minimize taxes can be effective for most businesses, as is the approach of bunching deductible expenses into this year or next to maximize their tax value.

Do you expect to be in a higher tax bracket next year? If so, then opposite strategies may produce better results. For example, you could pull income into 2024 to be taxed at lower rates, and defer deductible expenses until 2025, when they can be claimed to offset higher-taxed income.

Here are some other ideas that may help you save tax dollars if you act soon.

Estimated taxes

Make sure you make the last two estimated tax payments to avoid penalties. The third quarter payment for 2024 is due on September 16, 2024, and the fourth quarter payment is due on January 15, 2025.

QBI deduction

Taxpayers other than corporations may be entitled to a deduction of up to 20% of their qualified business income (QBI). For 2024, if taxable income exceeds $383,900 for married couples filing jointly (half that amount for other taxpayers), the deduction may be limited based on whether the taxpayer is engaged in a service-type business (such as law, health or consulting), the amount of W-2 wages paid by the business, and/or the unadjusted basis of qualified property (such as machinery and equipment) held by the business. The limitations are phased in.

Taxpayers may be able to salvage some or all of the QBI deduction (or be subject to a smaller deduction phaseout) by deferring income or accelerating deductions to keep income under the dollar thresholds. You also may be able increase the deduction by increasing W-2 wages before year end. The rules are complex, so consult us before acting.

Cash vs. accrual accounting

More small businesses are able to use the cash (rather than the accrual) method of accounting for federal tax purposes than were allowed to do so in previous years. To qualify as a small business under current law, a taxpayer must (among other requirements) satisfy a gross receipts test. For 2024, it’s satisfied if, during the three prior tax years, average annual gross receipts don’t exceed $30 million. Cash method taxpayers may find it easier to defer income by holding off on billing until next year, paying bills early or making certain prepayments.

Section 179 deduction

Consider making expenditures that qualify for the Section 179 expensing option. For 2024, the expensing limit is $1.22 million, and the investment ceiling limit is $3.05 million. Expensing is generally available for most depreciable property (other than buildings) including equipment, off-the-shelf computer software, interior improvements to a building, HVAC and security systems.

The high dollar ceilings mean that many small and midsize businesses will be able to currently deduct most or all of their outlays for machinery and equipment. What’s more, the deduction isn’t prorated for the time an asset is in service during the year. Even if you place eligible property in service by the last days of 2024, you can claim a full deduction for the year.

Bonus depreciation

For 2024, businesses also can generally claim a 60% bonus first-year depreciation deduction for qualified improvement property and machinery and equipment bought new or used, if purchased and placed in service this year. As with the Sec. 179 deduction, the write-off is available even if qualifying assets are only in service for a few days in 2024.

Upcoming tax law changes

These are just some year-end strategies that may help you save taxes. Contact us to customize a plan that works for you. In addition, it’s important to stay informed about any changes that could affect your business’s taxes. In the next couple years, tax laws will be changing. Many tax breaks, including the QBI deduction, are scheduled to expire at the end of 2025. Plus, the outcome of the presidential and congressional elections could result in new or repealed tax breaks.

Are you liable for two additional taxes on your income?

Having a high income may mean you owe two extra taxes: the 3.8% net investment income tax (NIIT) and a 0.9% additional Medicare tax on wage and self-employment income. Let’s take a look at these taxes and what they could mean for you.

1. The NIIT

In addition to income tax, this tax applies on your net investment income. The NIIT only affects taxpayers with adjusted gross incomes (AGIs) exceeding $250,000 for joint filers, $200,000 for single taxpayers and heads of household, and $125,000 for married individuals filing separately.

If your AGI is above the threshold that applies ($250,000, $200,000 or $125,000), the NIIT applies to the lesser of 1) your net investment income for the tax year, or 2) the excess of your AGI for the tax year over your threshold amount.

The “net investment income” that’s subject to the NIIT consists of interest, dividends, annuities, royalties, rents and net gains from property sales. Wage income and income from an active trade or business aren’t included. However, passive business income is subject to the NIIT.

Income that’s exempt from income tax, such as tax-exempt bond interest, is likewise exempt from the NIIT. Thus, switching some taxable investments to tax-exempt bonds can reduce your exposure. Of course, this should be done after taking your income needs and investment considerations into account.

Does the NIIT apply to home sales? Yes, if the gain is high enough. Here’s how the rules work: If you sell your principal residence, you may be able to exclude up to $250,000 of gain ($500,000 for joint filers) when figuring your income tax. This excluded gain isn’t subject to the NIIT.

However, gain that exceeds the exclusion limit is subject to the tax. Gain from the sale of a vacation home or other second residence, which doesn’t qualify for the exclusion, is also subject to the NIIT.

Distributions from qualified retirement plans, such as pension plans and IRAs, aren’t subject to the NIIT. However, those distributions may push your AGI over the threshold that would cause other types of income to be subject to the tax.

2. The additional Medicare tax

In addition to the 1.45% Medicare tax that all wage earners pay, some high-wage earners pay an extra 0.9% Medicare tax on part of their wage income. The 0.9% tax applies to wages in excess of $250,000 for joint filers, $125,000 for married individuals filing separately and $200,000 for all others. It applies only to employees, not to employers.

Once an employee’s wages reach $200,000 for the year, the employer must begin withholding the additional 0.9% tax. However, this withholding may prove insufficient if the employee has additional wage income from another job or if the employee’s spouse also has wage income. To avoid that result, an employee may request extra income tax withholding by filing a new Form W-4 with the employer.

An extra 0.9% Medicare tax also applies to self-employment income for the tax year in excess of the same amounts for high-wage earners. This is in addition to the regular 2.9% Medicare tax on all self-employment income. The $250,000, $125,000, and $200,000 thresholds are reduced by the taxpayer’s wage income.

Mitigate the effect

As you can see, these two taxes may have a substantial effect on your tax bill. Contact us to discuss how the impact could be reduced.

Navigating tax complexities: Craft partnership agreements and LLC operating agreements with precision

Partnerships are often used for business and investment activities. So are multi-member LLCs that are treated as partnerships for tax purposes. A major reason is that these entities offer federal income tax advantages, the most important of which is pass-through taxation. They also must follow some special and sometimes complicated federal income tax rules.

Governing documents

A partnership is governed by a partnership agreement, which specifies the rights and obligations of the entity and its partners. Similarly, an LLC is governed by an operating agreement, which specifies the rights and obligations of the entity and its members. These governing documents should address certain tax-related issues. Here are some key points when creating partnership and LLC governing documents.

Partnership tax basics

The tax numbers of a partnership are allocated to the partners. The entity issues an annual Schedule K-1 to each partner to report his or her share of the partnership’s tax numbers for the year. The partnership itself doesn’t pay federal income tax. This arrangement is called pass-through taxation, because the tax numbers from the partnership’s operations are passed through to the partners who then take them into account on their own tax returns (Form 1040 for individual partners).

Partners can deduct partnership losses passed through to them, subject to various federal income tax limitations such as the passive loss rules.

Special tax allocations

Partnerships are allowed to make special tax allocations. This is an allocation of partnership loss, deduction, income or gain among the partners that’s disproportionate to the partners’ overall ownership interests. The best measure of a partner’s overall ownership interest is the partner’s stated interest in the entity’s distributions and capital, as specified in the partnership agreement. An example of a special tax allocation is when a 50% high-tax-bracket partner is allocated 80% of the partnership’s depreciation deductions while the 50% low-tax-bracket partner is allocated only 20% of the depreciation deductions.

Any special tax allocations should be set forth in the partnership agreement. However, to make valid special tax allocations, you must comply with complicated rules in IRS regulations.

Distributions to pay partnership-related tax bills

Partners must recognize taxable income for their allocations of partnership income and gains — whether those income and gains are distributed as cash to the partners or not. Therefore, a common partnership agreement provision is one that calls for the partnership to make cash distributions to help partners cover their partnership-related tax liabilities. Of course, those liabilities will vary, depending on the partners’ specific tax circumstances. The partnership agreement should specify the protocols that will be used to calculate distributions intended to help cover partnership-related tax bills.

For instance, the protocol for long-term capital gains might call for distributions equal to 15% or 20% of each partner’s allocation of the gains.

Such distributions may be paid out in early April of each year to help cover partners’ tax liabilities from their allocations of income and gains from the previous year.

Contact us for assistance

When putting together a partnership or LLC deal, tax issues should be addressed in the agreement. Contact us to be involved in the process.

Working remotely is convenient, but it may have tax consequences

Many employees began working remotely during the pandemic and continue doing so today. Remote work has many advantages for employers and employees, and as a result, it’s here to stay in many industries. But it may also lead to some tax surprises, especially if workers cross state lines.

Double taxation may occur

It’s not unusual for employees to work remotely for an employer in another state. For some businesses, remote work has become a permanent arrangement that allows employees to live and work further away from a physical office.

If you live in one state and work remotely for an employer in another state, familiarize yourself with the tax laws in both states and determine how they may affect you. For example, you may need to file income tax returns in both states, which could result in increased — or even double — taxation.

Here’s the problem: A state generally has the power to tax the incomes of people who are domiciled in it as well as people who reside there. Domicile is a state of mind and is often based on a person’s intent to make a location his or her “true, fixed, permanent home.” Residency is based on physical presence in a state for a certain amount of time (typically, 183 days per year).

It’s possible to be domiciled in one state and a resident of another. For example, let’s say you have a permanent home in one state where your job is located and a vacation home in another state. Your employer allows employees to work remotely, so now you spend more than 200 days per year living and working at your vacation home. The state where your permanent home is located considers you to be domiciled there, but the state where your vacation home is located views you as a resident. So you may be subject to taxes on the same income in both states. You could avoid double taxation if one or both states provide credit for tax paid to other states. But your tax bill may still increase if, for example, one state’s income tax rate is significantly higher than the other state’s rate.

Complications for employers

From an employer’s perspective, allowing employees to work remotely may create obligations to withhold and remit income and payroll taxes in several states. Plus, having employees in other states may be sufficient to establish “nexus” with those states, potentially triggering liability for their income, franchise, gross receipts, or sales and use tax. In addition to the expense of tax reporting in multiple states, this may increase an employer’s overall tax liability. There are other complications as well.

Business expense deductions

Under current law, employees generally can’t deduct unreimbursed job-related expenses. Years ago, employees could claim certain costs as miscellaneous itemized deductions, which are deductible to the extent they exceed 2% of adjusted gross income. But those deductions were eliminated for 2018 through 2025.

Remote workers typically aren’t eligible for the home office deduction either. That deduction is generally limited to self-employed business owners. Prior to 2018, employees could claim the deduction if, among other things, they worked at home “for the convenience” of their employers. But that deduction was also eliminated for 2018 through 2025.

Employers may reimburse remote workers for their business expenses according to an “accountable plan” that requires employees to substantiate expenses and meet other requirements. Properly reimbursed expenses are deductible by an employer and excludable from an employee’s income.

Be aware of the consequences

If you’re a remote worker or own a business that employs remote workers, be sure you understand the tax implications. In some cases, you may be able to take steps to minimize them. But even if you can’t, it’s important to know what to expect.

Cash or accrual accounting: What’s best for tax purposes?

Your businesses may have a choice between using the cash or accrual method of accounting for tax purposes. The cash method often provides significant tax benefits for those that qualify. However, some businesses may be better off using the accrual method. Therefore, you need to evaluate the tax accounting method for your business to ensure that it’s the most beneficial approach.

The current situation

“Small businesses,” as defined by the tax code, are generally eligible to use either cash or accrual accounting for tax purposes. (Some businesses may also be eligible to use various hybrid approaches.) Before the Tax Cuts and Jobs Act (TCJA) took effect, the gross receipts threshold for classification as a small business varied from $1 million to $10 million depending on how a business was structured, its industry and whether inventory was a material income-producing factor.

The TCJA simplified the definition of a small business by establishing a single gross receipts threshold. It also increased the threshold to $25 million (adjusted for inflation), expanding the benefits of small business status to many more companies. For 2024, a small business is one whose average annual gross receipts for the three-year period ending before the 2024 tax year are $30 million or less (up from $29 million in 2023).

In addition to eligibility for the cash method of accounting, small businesses enjoy simplified inventory accounting, exemption from the uniform capitalization rules and the business interest deduction limit, and several other tax advantages. Be aware that some businesses are eligible for cash accounting even if their gross receipts are above the threshold, including S corporations, partnerships without any C corporation partners, farming businesses and certain personal service corporations. Also, tax shelters are ineligible for the cash method, regardless of size.

Potential advantages

For most businesses, the cash method provides significant tax advantages. Because cash-basis businesses recognize income when it’s received and deduct expenses when they’re paid, they have greater control over the timing of income and deductions. For example, they can defer income by delaying invoices until the following tax year or shift deductions into the current year by accelerating the payment of expenses.

In contrast, accrual-basis businesses recognize income when it’s earned and deduct expenses when they’re incurred, without regard to the timing of cash receipts or payments. That means they have little flexibility to time the recognition of income or expenses for income tax purposes.

The cash method also provides cash flow benefits. Because income is taxed in the year it’s received, it helps ensure that a business has the funds it needs to pay its tax bill.

For some businesses, however, the accrual method may be preferable. For instance, if a company’s accrued income tends to be lower than its accrued expenses, the accrual method may result in lower tax liability than the cash method. Other potential advantages of using the accrual method include the abilities to deduct year-end bonuses paid within the first 2½ months of the following tax year and to defer taxes on certain advance payments.

Issues when switching methods

Even if your business would enjoy a tax advantage by switching from the accrual method to the cash method, or vice versa, it’s important to consider the administrative costs involved in making the change. For example, if your business prepares its financial statements in accordance with U.S. Generally Accepted Accounting Principles (GAAP), it’s required to use the accrual method for financial reporting purposes.

Does that mean you can’t use the cash method for tax purposes? No, but it would require the business to maintain two sets of books. Changing accounting methods for tax purposes may also require IRS approval. Contact us to learn more about each method.

Do you owe estimated taxes? If so, when is the next one due?

Federal estimated tax payments are designed to ensure that certain individuals pay their fair share of taxes throughout the year. If you don’t have enough federal tax withheld from your paychecks and other payments, you may have to make estimated tax payments. This is the case if you receive interest, dividends, self-employment income, capital gains, a pension or other income that’s not covered by withholding.

Individuals must pay 25% of a “required annual payment” by April 15, June 15, September 15, and January 15 of the following year, to avoid an underpayment penalty. If one of those dates falls on a weekend or holiday, the payment is due on the next business day.

So the third installment for 2024 is due on Monday, September 16 because the 15th falls on a Sunday. Payments are made using Form 1040-ES.

The amount due

The required annual payment for most individuals is the lower of 90% of the tax shown on the current year’s return or 100% of the tax shown on the return for the previous year. However, if the adjusted gross income on your previous year’s return was more than $150,000 ($75,000 if you’re married filing separately), you must pay the lower of 90% of the tax shown on the current year’s return or 110% of the tax shown on the return for the previous year.

Most people who receive the bulk of their income in the form of wages satisfy these payment requirements through the tax withheld by their employers from their paychecks. Those who make estimated tax payments generally do so in four installments. After determining the required annual payment, divide that number by four and make four equal payments by the due dates.

But you may be able to use the annualized income method to make smaller payments. This method is useful to people whose income flow isn’t uniform over the year, perhaps because of a seasonal business. For example, if your income comes exclusively from a business operated in a resort area during June, July, and August, no estimated payment is required before September 15.

The underpayment penalty

If you don’t make the required payments, you may be subject to an underpayment penalty. The penalty equals the product of the interest rate charged by the IRS on deficiencies, times the amount of the underpayment for the period of the underpayment.

However, the underpayment penalty doesn’t apply to you if:

The total tax shown on your return is less than $1,000 after subtracting withholding tax paid;
You had no tax liability for the preceding year, you were a U.S. citizen or resident for that entire year, and that year was 12 months;
For the fourth (January 15) installment, you file your return by that January 31 and pay your tax in full; or
You’re a farmer or fisherman and pay your entire estimated tax by January 15, or pay your entire estimated tax and file your tax return by March 1.

In addition, the IRS may waive the penalty if the failure was due to casualty, disaster or other unusual circumstances and it would be inequitable to impose the penalty. The penalty can also be waived for reasonable cause during the first two years after you retire (and reach age 62) or become disabled.

We can help

Contact us if you need help figuring out your estimated tax payments or you have other questions about how the rules apply to you.

Understanding taxes on real estate gains

Let’s say you own real estate that has been held for more than one year and is sold for a taxable gain. Perhaps this gain comes from indirect ownership of real estate via a pass-through entity such as an LLC, partnership or S corporation. You may expect to pay Uncle Sam the standard 15% or 20% federal income tax rate that usually applies to long-term capital gains from assets held for more than one year.

However, some real estate gains can be taxed at higher rates due to depreciation deductions. Here’s a rundown of the federal income tax issues that might be involved in real estate gains.

Vacant land

The current maximum federal long-term capital gain tax rate for a sale of vacant land is 20%. The 20% rate only hits those with high incomes. Specifically, if you’re a single filer in 2024, the 20% rate kicks in when your taxable income, including any land sale gain and any other long-term capital gains, exceeds $518,900. For a married joint-filing couple, the 20% rate kicks in when taxable income exceeds $583,750. For a head of household, the 20% rate kicks when your taxable income exceeds $551,350. If your income is below the applicable threshold, you won’t owe more than 15% federal tax on a land sale gain. However, you may also owe the 3.8% net investment income tax (NIIT) on some or all of the gain.

Gains from depreciation

Gain attributable to real estate depreciation calculated using the applicable straight-line method is called unrecaptured Section 1250 gain. This category of gain generally is taxed at a flat 25% federal rate, unless the gain would be taxed at a lower rate if it was simply included in your taxable income with no special treatment. You may also owe the 3.8% NIIT on some or all of the unrecaptured Section 1250 gain.

Gains from depreciable qualified improvement property

Qualified improvement property (QIP) generally means any improvement to an interior portion of a nonresidential building that’s placed in service after the date the building is placed in service. However, QIP does not include expenditures for the enlargement of the building, elevators, escalators or the building’s internal structural framework.

You can claim first-year Section 179 deductions or first-year bonus depreciation for QIP. When you sell QIP for which first-year Section 179 deductions have been claimed, gain up to the amount of the Section 179 deductions will be high-taxed Section 1245 ordinary income recapture. In other words, the gain will be taxed at your regular rate rather than at lower long-term gain rates. You may also owe the 3.8% NIIT on some or all of the Section 1245 recapture gain.

What if you sell QIP for which first-year bonus depreciation has been claimed? In this case, gain up to the excess of the bonus depreciation deduction over depreciation calculated using the applicable straight-line method will be high-taxed Section 1250 ordinary income recapture. Once again, the gain will be taxed at your regular rate rather than at lower long-term gain rates, and you may also owe the 3.8% NIIT on some or all of the recapture gain.

Tax planning point: If you opt for straight-line depreciation for real property, including QIP (in other words, you don’t claim first-year Section 179 or first-year bonus depreciation deductions), there won’t be any Section 1245 ordinary income recapture. There also won’t be any Section 1250 ordinary income recapture. Instead, you’ll only have unrecaptured Section 1250 gain from the depreciation, and that gain will be taxed at a federal rate of no more than 25%. However, you may also owe the 3.8% NIIT on all or part of the gain.

Plenty to consider

As you can see, the federal income tax rules for gains from sales of real estate may be more complicated than you thought. Different tax rates can apply to different categories of gain. And you may also owe the 3.8% NIIT and possibly state income tax, too. We will handle the details when we prepare your tax return. Contact us with questions about your situation.