Three Misconceptions About Capital Gains
All Create Unexpected Tax Liabilities
By now, most are well aware that capital gain tax rates are slated to increase on January 1st if Congress takes no action to stop it and many within the real estate community are forecasting an increase in activity before year end. Investors want to sell their properties and pay the gain while the maximum rate for individuals is 15%. Unfortunately some of those investors may not be looking at their situation with eyes wide open. Below we discuss three common situations facing investors and how a 1031 tax-deferred exchange can help.
The value of my property has not gone up much.
Many are now facing the realization that countless property values have decreased in the last few years and believe selling would result in minimal gain and perhaps even a loss. While it is true that there may be minimal or no capital gain taxes due on the appreciation, many investors don’t realize they must also recapture depreciation which is taxed at a much higher rate. All depreciation taken over the years of ownership is generally recaptured at 25% regardless of your tax bracket. See the following examples:
Beach rental property acquired in 2004 for $800,000
Depreciated over a 27.5 year life
6 years of depreciation = $172,121
$172,121 x 25% = $43,030 depreciation recapture due
Commercial warehouse acquired in 2004 for $1,000,000
Depreciated over a 39 year life
6 years of depreciation = $151,709
$151,709 x 25% = $37,927 depreciation recapture due
These investors would recapture a significant amount of depreciation resulting in a hefty tax bill – even if the property sold for the original purchase price! A 1031 exchange enables you to defer the capital gain as well as the depreciation recapture.
I won’t net much cash so my gain is minimal.
Unfortunately your equity has nothing to do with your gain. Equity is the amount of cash in your property after your mortgage payoff. Your gain is the same whether you own your property free and clear or if you owe 100% of the sale price to your lender. As explained above, your capital gains are determined by deducting your net selling price from your basis. With interest rates so low in recent years, a number of investors have refinanced and pulled a significant amount of their equity out of the property and if they decide to sell, often the net proceeds (contract sale price less closing costs less the mortgage payoff) will not cover the tax liability.
A 1031 exchange is often beneficial when the investor does not have enough cash available to pay the tax or prefers not to use his cash to pay the tax when he desires to invest in other real estate.
I exchanged into the property I am selling now.
When acquiring property though a 1031 exchange, you carryover the basis of your relinquished property. When selling this property without doing another 1031 exchange, your gain is determined using your old basis and recapturing all depreciation taken on the current property as well as your old property. Obviously, doing another 1031 exchange will enable you to defer the gain and depreciation recapture again.
An exchange provides a solution for these situations but all investors are encouraged to consider a 1031 exchange when selling a business use or investment property. Selling a property and deferring the gain enables you to use all of your proceeds towards your replacement property and coupled with historically low interest rates you may be able to acquire a property that was unattainable just a few years ago. This keeps your equity working and you benefit from the time value of your deferral. All in all, 1031 exchanges are an excellent strategy to build your real estate portfolio with pre-tax dollars.