There are many factors that come into play when investing in real estate, not the least of which is the consideration of taxes. In 2013, investors are facing increased capital gains rates for higher income earners and an additional 3.8% surtax on investment income. Many residential and commercial real estate investors fall into the higher income categories, and they may want to consider a Section 1031 Exchange over a traditional real estate sale. The chart below indicates the new tax rates according to income.
What is a Section 1031 Exchange – I’ve never heard of it?
Section 1031 has been a part of the tax code since 1921. It allows the seller of an investment property to postpone recognition of gain provided the seller acquires another “like-kind” property within the timing requirements specified.
By postponing the capital gains taxes from the transaction, property sellers increase their purchase power on future properties. With the money that would otherwise have gone towards taxes, they can reinvest in larger, and perhaps higher-income earning, replacement properties.
Consider this hypothetical case prepared by the First American Exchange Company:
You purchased a rental property from $100,000 several years ago, which now has a mortgage balance of $50,000. You have made no capital improvements to the property, but have taken $50,000 in depreciation deductions.
You would like to sell the building for $200,000. If you simply sell it and choose to pay capital gains at current rates, you would owe $12,500 in depreciation recapture (which is taxed at 25%), $15,000 in capital gains taxes (at 15%), plus whatever tax your state levies on capital gains (Washington does not levy state capital gains taxes). You would owe $27, 500 in taxes if you sold conventionally. After paying off the mortgage balance, you would have a net proceed of $122,500 to invest elsewhere.
If instead of a conventional sale, you structured the transaction as a tax-deferred 1031 exchange, you would pay zero in federal or state taxes, and have $150,000 in cash available to acquire a new income property – commercial, retail or residential.
Given this scenario, you could use your $150,000 cash in hand to make the down payment on a $600,000 building. Had you gone the conventional tax route, your $122,500 would have limited you to an investment less than $500,000.
At some point down the line, you or your estate will probably have to reckon with the IRS because the taxes are not forgiven – just deferred. You also move your tax basis to the replacement property and that cuts your depreciation deductions.
Bottom line, many real estate investors are beginning to do the calculation and are finding that 1031 options are looking better and better.
If you want to know more about real estate investing or are interested in finding some properties, call Team Troy today at 206-588-8409 – we have an investor specialist whose job is just that.