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The real power of a 1031 exchange is not just the tax savings — it is the tremendous increase in purchasing power generated by this tax savings. With the advantages of leverage, every dollar saved in taxes allows a taxpayer to generally purchase multiple times more real estate when taking advantage of debt financing. Many taxpayers are surprised to discover that capital gain taxes are far higher than 15% or 20% federal tax rates. State taxes, which can be as high as 13.3% in some states, are added to the federal capital gain tax owed. In addition, depreciation deducted over the ownership period is recaptured and taxed at a rate of 25%. Finally, when applicable, some taxpayers may also have to pay an additional 3.8% net investment income tax on certain income over threshold amounts of $200,000 for single filers and $250,000 for married couples filing jointly. The net result is often a large percentage of a taxpayer’s  profits could be going directly to pay the four potential levels of taxation. Under the 4th calculation below, the net equity times four (assuming a 25% down payment and a 75% loan-to-value ratio) is the value of a replacement property a taxpayer could purchase after paying all capital gain taxes.

Under the 5th calculation involving a 1031 exchange, no taxes are recognized in the current tax year, leaving the full purchasing power of the entire gross equity to acquire more real property held for investment. In just one transaction, the taxpayer who chooses to exchange versus sell and pay capital gain and other taxes has the potential to acquire more investment property than a taxpayer who sells and will ultimately only retain the net proceeds after-taxes are paid.

Analyze the Benefits of an Exchange Before You Sell

1. CALCULATE NET ADJUSTED BASIS
      Original Purchase Price __________
      + Improvements __________
      – Depreciation __________
      = NET ADJUSTED BASIS __________
2. CALCULATE CAPITAL GAIN
      Sales Price __________
      – Net Adjusted Basis __________
      – Cost of Sale __________
      = CAPITAL GAIN __________
3. CALCULATE CAPITAL GAIN TAX DUE
      Recaptured Depreciation (25% ) __________
      + Federal Capital Gain (15% or 20%) __________
      + Medicare Surtax (when applicable 3.8%) __________
      + State Tax (when applicable) __________
      = TOTAL TAX DUE __________
4. ANALYZE PURCHASE-NO EXCHANGE
      Sales Price __________
      – Cost of Sale __________
      – Loan Balances __________
      = GROSS EQUITY __________
      – Capital Gain Taxes Due __________
      = NET EQUITY __________
      Net Equity X 4 = __________
5. ANALYZE PURCHASE-EXCHANGE
      Capital Gain Taxes Due __________
      Gross Equity = Net Equity __________
      Gross Equity x 4 = __________
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