Everyone breathed a sigh of relief when the tax cuts were extended at the end of last year for another two years. Although it is good for real estate investors that the maximum federal capital gains rate will remain at 15% for the next two years, savvy investors know that they really pay much more tax than that when they sell their properties. Even if your gain is not substantial due to a downturn in the market, it’s important to know and calculate the different ways you may be taxed before deciding whether to cash out or defer your tax in a 1031 exchange.
Additional Tax Liabilities
When you sell improved investment property, you must pay tax on recapture of depreciation. Even if you have absolutely no gain due to appreciation, you will owe tax at the rate of 25% of the amount that you depreciated, or could have depreciated, during the time you owned the property.
In many states you must also pay state tax on the gain. Depending on the state you reside in, the state tax can add almost an additional 10% on to the tax rate. For example, if the state tax is 9% and if you are selling property worth $1 million that you bought for $600,000 and on which you took $100,000 depreciation, your tax liability would be calculated as follows:
15% federal tax on the appreciation in value of $400,000 Tax = $60,000
25% recapture of depreciation tax on $100,000 of depreciation Tax = $25,000
9% state tax on $500,000 of gain and recapture of depreciation Tax = $45,000
Total tax due $130,000
(This is just an example to illustrate how much tax you may have to pay. Please consult with your tax advisor to compute the actual tax in your situation.)
Carryover of Gain from Prior Exchanges
Another point to remember is that every time you do an exchange, the gain that you don’t pay tax on is deferred rather than excluded, so your basis will reflect all of that deferred gain. If you sell property in a down market and have no gain from appreciation, you may still have to pay tax on gain which was deferred in prior 1031 exchanges.
Medicare Tax in 2013
Starting in 2013, high income taxpayers will also be paying an additional 3.8% Medicare tax on all “unearned” income, which includes capital gains from the sale of real estate. This tax will apply only to taxpayers who earn more than $200,000 ($250,000 for married couples filing jointly).
Defer Your Taxes in a 1031 Exchange
Fortunately for investors, we still have the benefits of IRC Section 1031, which is the most effective way to defer these taxes. Provided that you acquire property in an exchange that is at least equal to the fair market value of what you sold, and you invest all of your net cash from the relinquished property into the replacement property, you will be able to defer your tax until you ultimately sell the property. At your option, you can do another 1031 exchange when you sell that property and defer the tax further. Since the step up in basis rules are now back, investors will be able to continue deferring tax by completing 1031 exchanges, and eventually pass on their real estate to their heirs with a step up in basis equal to the fair market value of the property at the time of their death. This means that the tax will never be paid by those heirs.
As with any transaction, it is important to consult with your own tax advisor. This is just a discussion of the general rules, and the tax laws may change. If you are interested in starting a tax-deferred exchange, contact your Realtor who can get you started with a local exchange company.
Adapted from The EXCHANGE Update, First American Exchange Company