Whether you are selling a stock, bond, rental property, or any taxable asset of value for profit, there are always capital gain taxes associated with the sale. When a sale is triggered or “realized” the IRS will categorize this as a taxable event leaving the seller with a tax liability (levy).
Often this liability can be rather significant leaving the seller with much less proceeds to reinvest after satisfying the IRS. Fortunate for property owners, real estate has many tax benefits associated with them including the potential to defer all capital gain taxes.
In this article we will touch briefly on topics related to capital gain taxes including:
· What are Short-Term Capital Gains?
· What are Long-Term Capital Gains?
· Key Differences between Short-Term & Long-Term Capital Gains?
· How to Calculate Long-Term and Short-Term Capital Gains?
· Solutions to Paying Capital Gain Taxes
What are Short-Term Capital Gains?
As regular taxable income, short-term gains are defined as a gain on an investment which is realized in under one year. These gains are subject to whichever marginal income tax bracket you fall under. There are currently seven U.S. federal tax brackets, with rates ranging from 10% to 37%.
For example, if you have $80,000 in taxable income from your salary and $10,000 from short-term investments, then your total taxable income is $90,000. The taxes paid on short-term capital gains follow the same tax brackets as ordinary income.
Ordinary income is taxed at graduated rates depending on your income. It's possible that a short-term capital gain (or partial gain) may be taxed at the higher rate than your regular earnings. Reasoning behind this is because the capital gain may cause part of your overall income to rise into a higher marginal tax bracket.
In our above example, using the 2022 income tax rates, and assuming you are filing as a single person, you would be in the 22% tax bracket with your taxable income from your salary. The first $9,950 that you earn would be taxed at 10%, your income from $9,951 up to $40,525 would be taxed at 12%, and only the income from $40,525 to $86,375 would be taxed at 22%.
Part of your $10,000 capital gain - the portion up to the $86,375 limit for the bracket would be taxed at 22%. The remaining $3,625 gain, however, would be taxed at 24%, the rate for the next highest tax bracket.
What are Long-Term Capital Gains?
Long-term capital gains are defined as gains on an investment held for one year or longer. After the passage of the Tax Cuts and Jobs Act (TCJA), the tax treatment of long-term capital gains changed. The TCJA created unique tax brackets for long-term capital gains tax.
Under current US federal tax policy, the capital gain tax rate applies only to profits from the sale of assets held for more than one year. The current rates are 0%, 15% or 20%, depending on the taxpayer’s tax bracket for the given year.
Most real estate transactions fall in the category of long-term capital gains due to the long-term investment nature of owning real estate.
Key Differences between Short-Term & Long-Term Capital Gains?
Short-term capital gains result in the sale of an asset owned for one year or less. While long-term capital gains are generally taxed at a more favorable rate than salary or wages, short-term gains do not benefit from any special tax rates. They are subject to taxation as ordinary income.
Rates: 10% to 37%
Long-term capital gains are almost always lower than if the same asset is sold and you realize the gain in less than a year. Because long-term capital gains are generally taxed at a more favorable rate than short-term capital gains, investors can minimize capital gains tax by holding assets for one year or more.
Rates: 0%, 15% or 20%
How to Calculate Long-Term and Short-Term Capital Gains?
1. Calculate Net Adjusted Basis
First, determine the original cost basis of the purchase. You can look up the purchase price on the county appraiser site the property is held in.
Second, add up all capital improvements made to the property over time. These are any permanent improvements that add value to the property including construction, repairs, appliances, roof, HVAC, plumbing, siding, windows, etc.
Third, subtract all depreciation taken against the property over the period of ownership. Keep in mind, the IRS implements a 25% depreciation recapture tax upon the sale of the property.
For example, if you have taken $100,000 of depreciation against the property during the time of ownership, the IRS will bill you for $25,000 in depreciation recapture taxes.
Net Adjusted Basis = Original Purchase Price + Improvements – Depreciation
2. Calculate Equity
Equity is the value of an asset excluding the liabilities owed. Liabilities can be all mortgage debts and sales expenses related to selling a property including transfer taxes, stamp taxes, sales commissions, advertising fees, legal fees, and any mortgage points or other loan charges paid.
Equity = Sales Price – Sale Expenses – Debt
3. Calculate Capital Gains
To calculate the capital gains, you simply take the net sales price then subtract your net adjusted basis and sales expenses (costs).
Capital Gains = Sales Price – Adjusted Cost Basis – Sales Expenses
Solutions to Paying Capital Gain Taxes
There are many creative ways to defer paying capital gain taxes, with the leading strategy being a 1031 Exchange. In a nutshell, a 1031 exchange allows an investor to defer all capital gain and depreciation recapture taxes by rolling all proceeds from the sale of a property into a replacement property of equal to or higher value.
The most popular choice 1031 exchange investors are taking advantage of today is the Delaware Statutory Trust. A DST is a unique fund structure which allows exchange investors the ability to sell a property and exchange directly into a professionally managed, institutional grade replacement property. This fund structure gives the exchanger the flexibility to diversify their portfolio with institutional grade real estate while deferring all capital gains and depreciation recapture taxes. Read “10 Advantages of Owning a Delaware Statutory Trust (DST)” for more benefits on DSTs.
Marzo Capital Group offers exchange investors one of the largest selections of institutional grade replacement properties.
Refer to our 1031 exchange calculators to help assist in your exchange.
We hope this article helped shed some light on the various types of capital gain taxes and the viable options an investor has to preserve their capital. Knowing what capital gain taxes are and how to calculate them can play a crucial role in understanding how to plan for future liabilities.
Among many strategies in the industry, the 1031 exchange trumps most allowing an investor to fully defer all capital gain and depreciation recapture taxes. This gives an investor the ability to capture a higher tax equivalent yield going into their replacement property.
Although the process can be complicated and tax codes are consistently changing, having the opportunity to defer paying capital gains taxes is well worth the effort. Of course, there are many specific details we were not able to cover in this article, so do your research and consult with experts before jumping into the process.
If you are ready to start a 1031 exchange, or have any additional questions about how it might work for your specific situation, schedule a consultation with one of our experts at Marzo Capital Group.
To learn more about real estate investing and how a 1031 can complement your portfolio, visit the Marzo Capital Group Learning Center.
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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