CONSIDER THESE ISSUES BEFORE CLOSING ON PROPERTY HELD FOR INVESTMENT
Assume a married California couple has held an investment property for many years and upon selling will have $1,000,000 in proceeds (after closing costs). Also, assume this property has $900,000 of capital gain of which $300,000 of this gain is due to depreciation recapture. As you can see in the comparison below, taxpayers who exchange can obtain considerably higher investment returns from deferring the payment of capital gain taxes and redeploying this equity into other investment property. Taxpayers should explore the possibility of a 1031 exchange before closing on the sale of investment property.
| SALE (CASH OUT) | 1031 EXCHANGE (REINVEST) | |
|---|---|---|
| Capital Gain Taxes Owed | $348,900 | $0 (no taxes owed in the current tax year) |
| Net Income to Invest | $651,100 (proceeds less taxes owed) 1-5% possible cash flow (assume 2%) | $1,000,000 (entire amount of proceeds received). Many real estate investments provide 6-10% cash flow (assume 8%). |
| Possible Income | Bank CD, Bond Fund, Money Market. Assuming a 2% ** return on $651,100$13,022 annual income; $1,085/monthly income | Residential Rental, Commercial, Agricultural Land, etc. Assuming a 8% return on $1,000,000. $80,000/annual income; $6,666/monthly income. |
| Preferential Tax Treatment | Income is not tax-favored if earnings are in a non tax-qualified account. May be fully taxable. | Income generated is tax-favored. Income can be partially sheltered with write-offs. Depreciation tax benefits are also available. |
| Liquidity | Very liquid if 100% cash | Real Estate is generally not very liquid. |
| Diversification | Yes | Yes, but must reinvest in real property. May diversify by asset sand/or geography. |
| Time Restrictions | None | Yes, 45 days to identify replacement property. Maximum of 180 days to close on the replacement property. |
| Replacement Asset Basics | Basis equals purchase price | Only partial basis for new depreciation. Basis equals purchase price minus deferred gain. |
FOOTNOTES
* Depreciation Recapture: $300,000 x 25% = $75,000; Remaining Federal Capital Gain: $600,000 x 20% = $120,000; State Taxes: $900,000 x 13.3% = $119,700
Net investment Income tax: $900,000 x 3.8% = $34,200 Total Taxes = $348,900 After-Tax Proceeds Available: $1,000,000 – $348,900 = $651,100.
** Low rates of return for money market accounts, bank CDs and other liquid investments tilt the consideration in favor of a 1031 exchange.