Selling a property or business can be one of the happiest days an owner experiences. 😄 But it's not until the K1s are filed and the gain is reported to the IRS that the celebrations should really begin.

Every year I see a few of the same mistakes made on returns - many from other tax preparers, but some come from my own team that we have to send back through QC. These can shave off percentage points of IRR. 🧮

Today, we're talking about some of the biggest errors I see in the year of a sale of a property or business:

Net investment income tax on active businesses 📫
Reverse cost segregation analysis missing 🏚️
Activity not marked as final 👋

Mistake #1: Net Investment Income Tax Applied to an Active Business

If you sell an "active business" (a business you worked in, or were GP of) and recognize a tax gain, that gain should not be subject to the 3.8% net investment income tax on Form 8960 (affectionately referred to as the Obamacare tax). 🩻

But here's what I see: The partnership reports the sale proceeds. The accounting gets done. The gain flows through to the K1. Then someone calculates the 3.8% tax on it like it's passive investment income because that's what the software does automatically. 🧑‍💻

But this tax only applies to passive income. Active business income is excluded from the 3.8% calculation - a manual input in our tax entry. 👐 When you sell an active business you've been materially participating in, the profit is not passive income just because you sold it that year.

The distinction matters because that 3.8% can add meaningful dollars to a tax bill. For example, on a $1 million gain, an incorrect 3.8% assessment is $38,000. 🤑

And if you sell on a seller note, all your gains may still be tainted going forward.

But there is good news. You CAN amend for this if it's within the 3 year window. We've done this for several clients and gotten them back hundreds of thousands in overpaid tax.

If you're digging this, remember that I do paid calls to jam on any of this and more.

But a cheaper option is to get the 6 page deep dive into real estate strategies (many of which apply to non-real estate). It includes the Reverse Cost Seg (4797 Optimization) and is only $67 (😉) to help offset the monthly cost of this newsletter. 🙏

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Mistake #2: Reverse Cost Segregation Not Done

When you sell a property or business, the sales price gets broken down and allocated to different asset types on Form 4797. 🪑 🖼️ 🏢 This is called the purchase price allocation, and it matters because different asset classes get taxed differently.

Some assets like furniture, equipment, and certain improvements get taxed as ordinary income when they're sold (the dreaded "recapture"). 👻 That's because you took depreciation deductions on them over the years, and the IRS recaptures that depreciation at ordinary tax rates. Other assets like land get long-term capital gains treatment, which is taxed at lower rates.

Here's where the mistake happens: The proceeds get divided up pro rata - because that's just what accountants default to. That means if the building is 80% of the original purchase price, the gain gets allocated 80% to the building. If equipment was 20% of the price, the gain gets allocated 20% to equipment. It's simple and proportional - an accountants dream. 🤌

But it's often wrong. Fair value is the most right method. You need to look at what each asset class is actually worth at the time of sale, 🔍 not just divide the sale price the same way you divided the original purchase price.

This matters because of how it affects your tax bill. If proceeds get allocated pro rata, you might end up assigning more gain to depreciable assets that trigger ordinary income tax rates. ↗️ If instead you allocate based on fair value and more of the gain goes to land (which has no recaptured depreciation), more of your gain qualifies for the lower long-term capital gains rate. ↘️

For example, say you bought a property for $1 million. Equipment was valued at $200,000 and land at $800,000. You took depreciation on the equipment over ten years. Now you sell for $1.5 million. The pro rata method would allocate $300,000 of gain to equipment and $1.2 million to land. But a fair value analysis at sale might show the equipment is now worth $100,000 and the land is worth $1.4 million. Under fair value allocation, only $100,000 of gain flows to equipment. The rest flows to land and gets long-term capital gain treatment instead of ordinary income treatment. This would save $17,000 in tax ($100,000 x 17% (difference in 37% ordinary rates and 20% capital gain rate)). 🤯

Put a zero behind those numbers and the difference in your tax bill can be substantial.

What to do: Before the K1 gets filed, ask your tax advisor how the sale proceeds were allocated on Form 4797. Ask specifically whether they used a pro rata method or a fair value method. If they used pro rata without analyzing the actual fair values at time of sale, help them. Share the real value of the property between the land, structure, improvements, and furniture.

Mistake #3: Activity Not Marked as Final

Partnership K1s often break out multiple activities. You might own several rental properties, a business interest, and some other investments. Each one gets listed separately on the supplemental schedule that comes with the K1.

When an activity is disposed of during the year, it needs to be marked as "final" or "disposed" on that supplemental schedule. 📄 This tells the IRS, and more importantly, your tax preparer, that this activity ended during the tax year.

When this doesn't happen, passive losses from that activity can't be released in the year of sale. They get trapped. 🔒 You paid tax on the gain but can't use the accumulated losses to offset it.

What I see is the sale happens, the numbers flow through the partnership accounting, and nobody flags the activity as disposed. It sits there like it's still operating. The K1 shows income from the sale but doesn't show that the activity is done. This can be from a missed check-box on the K1 preparer, or from a personal tax return preparer not marking as final on their side. 🤷‍♂️

This is especially critical for passive real estate investors who are racking up passive losses from properties they have invested in that have done cost segregation studies. 📭

The Takeaway

Sale years are complicated tax years. 😫 The K1 that comes out is usually the first place you see the tax impact, and sometimes what you see isn't right.

Before you file your personal return, take twenty minutes to compare the K1 to what you know about the transaction. Ask your tax advisor about the three things above. These mistakes are common, but they're avoidable.

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