It’s a real estate investors’ dream—a property that highly appreciates in value over time. The downside to that dream, though, is the prospective hefty capital gains tax bill which can either trap that wealth in the property, or force the investor to pay a heavy price to the IRS upon the sale of the property.
Understanding the Tax Consequences
The tax basis that the IRS looks at is typically the cost of investment in the property when it was acquired, including the price of down payment, mortgage amount, closing and settlement costs. There can be adjustments to an investor’s original basis, including the amount spent on capital improvements. The capital gain, as determined by the IRS, is the property sale price minus the adjusted cost basis. Depending on the investor’s tax bracket, the federal tax on this gain can be up to 20 percent. Additionally, if the property was depreciated for tax purposes and is then sold for more than its depreciated value, there will also be a depreciation recapture tax, up to 25% at maximum rate, leading to an enormous double tax hit.
A prudent investor is aware of all the tax consequences and can take advantage of safe harbor opportunities to defer these taxes. One such safe harbor is a 1031 exchange, which allows the investor to defer gains by purchasing another property. Simply, 1031 is a federal tax code that allows an investor to defer capital gains taxes by reinvesting the proceeds of one business or investment asset into another.
According to the code, “No gain or loss shall be recognized on the exchange or property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment.”
Unlimited Tax Deferrals
A property investor can therefore indefinitely defer payments of capital gain and depreciation recapture taxes by continually reinvesting gains into qualified replacement properties.
The deferrals can be structured to last throughout the investor’s lifetime. Upon death, any heirs could then receive a step-up in cost basis if they decide to continue to exchange properties. That would eliminate the capital gain and depreciation recapture taxes in totality.
Because of this tax deferral, an investor has more capital on hand to reinvest. Investors can sell a property in an area at peak market value, and then use the sale money to take advantage of a market where real estate prices are in a downward trend, without having to give the IRS a large portion of the sale.
1031 exchanges are excellent vehicles for avoiding hefty capital gains taxes on property sales. They do require investors to use a qualified intermediary to handle the funds from the original sale through the exchange process. With careful consideration, this protects the investor, placing the transaction in the hands of someone who knows all the intricate details of the tax law, and who has the experience and expertise necessary to review the process and manage all problems that may arise.