One of the reasons real estate investors do a 1031 exchange is to defer the capital gains taxes on the sale of their ‘old’ real estate. Many people think that the capital gains tax on selling their real estate is just 15%. Not so! It’s actually much greater in most cases. Here’s why:
Too many people think that profit, or gain, is simply what you sold your old property for minus what you bought it for. Most of the time thatís not accurate. Gain is actually calculated by taking your net sales price and subtracting your adjusted basis.
But it doesnít stop there. Not only are you going to be taxed on the appreciation or gain of your real estate, but also on the Ďrecapture of depreciation,í more accurately called ĎSection 1250 Gain.í
Donít make the mistake of thinking that since you didnít depreciate your old property you wonít be taxed on that depreciation. Quite the opposite: unless itís bare land, the IRS will make you pay the tax at 25% on the depreciation, regardless of whether you took it or not!
And thatís just the Feds! Thereís also the State capital gains tax, which could be as high as 9.9%.
So, if you sell real estate, and you think your tax will only be 15% federal long-term capital gains, think again. There may actually be THREE tax bites: 25% on depreciation recapture, the normal 15% federal capital gains tax, and finally the State capital gains tax on the entire gain.
Your blended effective tax rate will probably be higher than just 15%. Depending on the state you live in and the amount of depreciation, the blended rate could be as high as 35%. Thatís over a third of the blood, sweat, toil and tears you expended when you went into real estate investing in the first place.
Are you ready for the salt in the wound? Thereís even the possibility you might have to pay yet another tax (Yes, a Ďfourthí type of tax). Itís called the ĎAMT,í or the ĎAlternative Minimum Tax.í
This example above is anecdotal, of course. Your actual capital gains tax might be lower. Or it might be higher. Your tax advisor or one of us here at The Experts can help you calculate your actual cap gain tax on your specific situation.
The Bottom Line:
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