So, you made a smart real estate investment and are now ready to sell your property for a substantial gain. However, after a little research you realized that you could owe a significant amount of taxes if you choose to sell. You don’t want to give all of your hard-earned money to the IRS, so what can you do?
If this sounds like you, a 1031 exchange could be the tax solution you are looking for.
In this article we cover the types of taxes you can defer by using a 1031 exchange, including:
- Capital Gain Tax (Short & Long Term)
- State Tax
- Net Investment Income Tax
- Depreciation Recapture Tax
Capital Gain Tax
Capital gains tax is calculated by taking the sale price of your property and subtracting out the adjusted basis (purchase price + capital improvements) and the cost of sale (expenses). You’ll want to talk to your accountant to accurately calculate the adjusted basis.
Capital Gains = Sale Price – Adjusted Basis (Purchase Price + Capital Improvements) – Costs of Sale (Expenses)
There are two types of capital gains tax that you need to know: short-term & long-term.
Short-term capital gains tax is used when you have owned the investment for less than a year. Any gain on this type of investment will be taxed as ordinary income, which tends to be a higher rate and can range anywhere from 10% to 37%.
Long-term capital gains tax is used when you have owned the investment for more than a year. In this case, you will be taxed at the long-term capital gains rate, which could be 0%, 15% or 20% depending on your taxable income. Although you’ll always be subject to federal income tax, your state income tax will vary depending on the state you live in.
State capital gain tax is used when an investor who resides in a state with state income tax, sells an investment property for a profit. State taxes can vary from 0% to upwards of 13% depending on the state you reside in. With the exception of AK, FL, NV, NH, SD, TN, TX, WA & WY; you will most likely be responsible to pay significant state capital gain taxes upon the sale of your asset(s).
Regardless of whether short-term, long-term or state tax apply in your case, all can be deferred by using a 1031 exchange.
Net Investment Income Tax
The Net Investment Income Tax (NIIT) is another potential tax obligation that can have a notable impact on your bottom line. This is an additional tax imposed by the IRS for income earners who make over $200,000 per year, or $250,000 per year if they file jointly. The NIIT rate is currently 3.8%, which will be added on top of any other taxes you owe as a result of selling your property.
Net investment income includes several different income streams, including capital gains, interest, dividends, passive income, rental income and more. In the case of selling your property, it’s the capital gains income that you’ll most likely pay taxes on under the NIIT if you weren’t using a 1031 exchange.
Depreciation Recapture Tax
If you’ve owned your property for several years, there’s a good chance that you have been taking advantage of depreciation to offset some of the taxable income. This is a common and often advisable practice, but upon the sale of your property the IRS will ask for a portion of that money back.
The IRS does this through the depreciation recapture tax. As the name suggests, this tax is intended to recapture a portion of the depreciated income that you previously offset. Upon the sale of your property, you will be taxed on the total value of the depreciation you have used while owning the property. The depreciation recapture tax is currently 25%.
For example, say you purchased a property for $500,000 and have owned it for five years. In this case, your depreciation per year would be $12,820 ($200,000/27.5) for a total of $64,102. Under the depreciation recapture tax, you would owe roughly $16,025.
As with the other taxes mentioned in this article, your depreciation recapture tax can also be deferred by using a 1031 exchange.
With so many potential taxes to pay when selling a property, it’s no wonder investors often choose to defer paying those taxes by utilizing the power of a 1031 exchange.
Our team at Marzo Capital Group are experts at the 1031 exchange process and can help you defer most, if not all, of the taxes related to selling your property and provide a suitable replacement. If you are interested in pursuing a 1031 exchange, schedule a consultation and we’d be happy to assist you.
Marzo Capital Group is not a licensed accountant or tax advisor. Please consult with your CPA before making any investment decisions.
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