USE 1031 EXCHANGES TO PURCHASE MORE PROPERTY
President Obama, in his State of the Union address on January 20th, outlined a number of tax increase proposals that his Administration projects would raise $320 billion in new revenue. Two of the President’s proposals would, if enacted, have a significant impact on real estate investors:
- Increase Capital Gain Tax Rate: The President has proposed increasing the top capital gain tax rate from 20% to 28%. Under current law, many real estate investors in the top tax bracket face an additional 3.8% tax on Net Investment Income under IRC Section 1411, resulting in a total tax rate of 23.8%. Under the President’s proposal, this would increase to 31.8%.
- Eliminate Stepped Basis at Death: Under current tax law, when a taxpayer dies, the taxpayer’s heirs receive a step-up in the basis of inherited property. The basis is stepped up to the fair market value of the asset on the date of death. President Obama has proposed eliminating this stepped-up basis, which will result in the built-in gain remaining in the property after it passes to the heirs. Although the President has proposed some small exclusions ($200,000 on general asset gains and $500,000 for a taxpayer’s primary residence), eliminating the stepped-up basis would seriously impact the heirs of investors who die with appreciated assets.
TAX PLANNING CERTAINTY – 1031 EXCHANGES
Tax strategies which take advantage of the current tax code are a much better way to achieve tax benefits today. IRC Section 1031 tax-deferred exchanges have been a part of the tax code since 1921. Section 1031 allows an investor who holds property for investment purposes, or for use in a trade or business, to defer all four (4) levels of potential capital gain taxes (federal capital gain, federal depreciation recapture, net investment income, and state capital gain) by exchanging for qualifying like-kind property under Section 1031. By deferring the capital gain tax, an investor has significantly more purchasing power and better overall investment returns.
Let’s compare the tax treatment for the sale of an investment property between: (i) paying all the taxes owed, or (ii) using a 1031 exchange to defer 100% of the taxes owed. We will assume the property has total capital gain of $1,300,000, $300,000 of which is from depreciation recapture, and $1,000,000 of which is from asset appreciation. For this example, we will assume this is a California investor who has a 13.3% state tax rate, and we will assume the investor is also paying the 3.8% net investment income tax (NIIT) on the entire capital gain:
|Depreciation Recapture||$300,000 X 25%||= $75,000|
|Federal Capital Gain Taxes||$1,000,000 X 20%||= $200,000|
|Net Investment Income Taxes||$1,300,000 X 3.8%||= $49,400|
|CA State Taxes||$1,300,000 X 13.3%||= $172,900|
|Total Taxes Owed:||$497,300|
|Sell in 2015, Pay Taxes:||$497,300 in taxes|
|Exchange in 2015, Defer Taxes:||$0 (no taxes owed)|
REPLACEMENT PROPERTY PURCHASE COMPARISON – SALE VS. EXCHANGE
Assume the investor in the previous example sold the relinquished property for a total net sales price of $2,000,000, with, as stated above, $1,300,000 of total capital gain. Assume the investor intends to apply the sales proceeds toward a 25% down payment on a replacement property, with conventional financing for the remaining 75% of the replacement property purchase price. We will compare how much property the investor who sells and pays all the taxes can purchase, versus how much property the investor who exchanges and defers 100% of the capital gains tax can purchase.
Sell in 2015 and Pay Taxes: ($2,000,000 – $497,300)= $1,502,700 X 4 = $6,010,800
Exchange in 2015 and Defer Taxes: ($2,000,000 – $0)= $2,000,000 X 4 = $8,000,000
By taking advantage of a 1031 exchange, the investor defers all taxes thus preserving their net sales proceeds for the purchase of better performing replacement property. In this comparison, the investor who exchanges versus sells is able to purchase a replacement property worth considerably more ($8,000,000 versus $6,010,800).
In times of economic and tax uncertainty, it is important to utilize the tax advantages currently available in the tax code. Call the experts at Asset Preservation to discuss 1031 exchanges and your investment property situation.