On this Free for All Friday¸ we are discussing the capital gain tax rates slated to increase on January 1st if Congress takes no action to stop it. 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 many 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.
Typically capital gains are determined by deducting your net selling price (contract sales price less closing costs) from the basis of your property (original purchase price including closing costs plus capital improvements less prior deferred gain). Many are now facing with the realization that property values have decreased in the last few years and selling would result in minimal gain and perhaps even a loss. While it true that there many be minimal or no capital gain taxes, 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 for 71 months with 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 71 months with 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 own 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 old basis and recapturing all depreciation taken on the current property as well as your old property. Obviously doing another 1031 exchange will enable to defer the gain and depreciation recapture again.
Summary
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 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.
Your tax advisor will be able to determine the tax consequences of selling your property. Use our 1031 Calculator to estimate how a 1031 exchange will benefit you.
