1031 Exchange, named after Section 1031 of the Internal Revenue Code, allows a real estate investor to defer (postpone) tax liability when selling one property and buying another. This raises an important question: How much income tax will I owe if I sell this property but do not acquire a replacement property?
Many investors underestimate their tax liability when selling real estate, usually because they don’t consider all of their separate tax liabilities. These include:
1. Federal capital gains tax
This is usually assessed at long-term rates for capital assets held longer than one year.
2. State and local income tax
These range from high-tax jurisdictions, like New York City, to states with no income taxes, like Wyoming.
3. Recaptured depreciation
At the federal level, this is taxed at a higher percentage rate than long-term capital gains (until upper brackets are reached). Recaptured depreciation is also taxed at the state level, but normally at state tax rates and not at a higher rate. (It is important to note that taking depreciation on improved real property is mandatory. Therefore, even if you have not taken the depreciation to which you are entitled during each tax year when sale occurs, the IRS will presume that you have taken it and impose the recaptured depreciation tax!)
4. Medicare tax under Obamacare
This is an additional 3.8 percent on net investment income, but only after you reach adjusted gross income (AGI) levels of $250,000 for married couples filing jointly (lower levels for single filers and unmarried). A single gain on a real estate transaction could push your AGI above the $250,000 mark and into the level where the Medicare tax becomes applicable.
Here is a ”back of the napkin” example for estimating income tax liability.
Penny Richman purchased a $225,000 fourplex as an investment property in 1990. She now has it under contract to sell for $475,000. Let’s estimate her tax liability:
RECAPTURED DEPRECIATION
If the fourplex is in an urban setting, we assume the nondepreciable land had a value of 10 percent of the purchase price or, in this example, $22,500. That leaves a depreciable basis on the building of $202,500.
Using a “straight-line” depreciation schedule of 27.5 years, we calculate the following accumulated depreciation: $202,500 / 27.5 = $7,363 per year X 15 years of ownership = $110,445.
(The useful life of 27.5 years is set by the IRS and applies only to residential investment property. The IRS applies a longer useful life to other commercial improvements of 39 years, straight line.)
In this example, the entire $110,445 will be recaptured and taxed without a 1031 exchange. With a 1031 exchange, properly executed, income tax liability—state and federal—would be deferred.
LONG TERM CAPITAL GAINS
The sale price is $475,000, but brokerage fees and closing costs are 7 percent, so the net sale price is: $475,000 x 0.93= $441,750.
Capital gains are imposed on the net sale price, minus the cost of the property:
$441,750-$225,000 = $216,750.
COMBINING THE TWO FOR THE TAX ESTIMATE
$110,445 X 30% = $33,133
This is the tax on recaptured depreciation, assuming a 25 percent federal tax rate and a 5 percent state tax rate.
$216,750 x 20% = $43,350
This is the tax on long-term capital gains, assuming a 15 percent federal tax rate and a 5 percent state tax rate.
TOTAL TAX DUE = $33,133 + $43,350 = $76,483
That’s ugly.
Remember, this is only an estimate. The result can be skewed by other variables, including: other investment income, higher tax brackets, lower tax brackets, differences in state taxes, accelerated depreciation and offsetting capital losses.
Deciding whether to perform a 1031 exchange is part of larger tax picture. However, for many investors, using a 1031 exchange to defer taxes is an obvious and correct choice. For most, leverage (borrowed money) is an effective part of the plan, and deferred taxes are like an interest-free loan from the government.
I’ve created a tax calculator to help investors out. You can access it at www.1031x.com/1031x-tax-calculator.
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