If late fee is part of lease, it is considered rental income

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Q. My husband and I own rental property in Florida. We have a management company prepare the lease and collect the rents. In our contract with the tenant, it is stated that when the rent is paid after the 3rd of the month, there will be a late fee of $50 and $5 each day that the tenant is late.

The tenant has been at least three weeks late every month for approximately one year. I know the management company is collecting some late payments, but we never see that money.

The lease states that the late fees will be considered as additional rent. My question to you: Should that late fee be part of the rent that we receive?

A. Yes, according to the terms of the lease, the late payments are rental income. I am surprised that you have not contacted the property manager to obtain an accounting of the late rent payments.

If the property management company is a real estate broker (which they should be under Florida law), all monies collected from rents should be held in and disbursed through the broker's trust account. This is a separate account that prohibits the comingling of the operating funds of the broker/property manager with funds collected for clients. Accordingly, a review of the funds collected should be straightforward.

Q. I purchased a house in Maryland 25 years ago for $70,000. I tried to sell the house last year asking $430,000 but was unsuccessful in this down market. I then put the house on a rental program and moved out of state.

My concern is that if the house is rented for more than three years and I then sell it, I will be subject to a capital gains tax. I am wondering if the capital gains amount would go back to the $70,000 original purchase price, or if there is a stepped up base of $430,000, reflecting its value when it became a rental.

A. Your capital gains tax will be based on the final net sales price less the $70,000 purchase price and the cost of any capital improvements that you made to the property. There is no change in your basis because you converted the property from a personal residence to a rental property.

For specific information on what the IRS requires and how the taxable basis of investment property is determined, go to www.irs.gov and review Publication 551, Basis of Assets.

The tax laws provide for an exclusion of a taxable gain in the sale of a personal residential property. Single homeowners are entitled to an exclusion of profits up to $250,000 and married couples filing jointly can earn tax-free profits of up to $500,000 on the sale of a personal residence. In order to qualify you must live in the property for two of the last five years before the sale. The two years do not have to be continuous.

For information on the rules, go to www.irs.gov and take a look a Publication 523, Selling Your Home.

Assuming that you made $50,000 in capital improvements to the property, your basis would be $120,000. If you sell the property for $430,000 (profit of $310,000) your taxable gain at a 15 percent federal rate would be $46,500 plus your state's capital gains tax.

Consequently, you may wish to return to the property before selling, or sell it now, to qualify under the exclusion rules.

The tax laws provide for an exclusion of a taxable gain in the sale of a personal residential property. Single homeowners are entitled to an exclusion of profits up to $250,000 and married couples filing jointly can earn tax-free profits of up to $500,000 on the sale of a personal residence.


Dr. Thomas Musil is the director of the Shenehon Center for Real Estate at the University of St. Thomas in Minneapolis. He has more than 25 years' experience as a broker, analyst, consultant and expert witness in real estate litigation and arbitration disputes. E-mail questions to: tamusil@stthomas.edu . Please include your name, city and state.


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