When selling real estate investment property, investors generally have two options:
- Pay the taxes on any gains from the sale, or,
- Conduct a 1031 exchange and defer the taxes owed.
Recently, because of the financial uncertainty surrounding 01and the overall state of the economy, some investors are choosing to pay the taxes on any gain from the sale of their investment properties and hold on to their cash rather than acquire replacement real estate utilizing the 1031 process.
While every investor is different and should make their own determination of their specific financial landscape and rely on the advice of their professional financial and legal counsel, there are generally two major points to keep in mind before choosing to pay the taxes rather than defer.
Point #1: The amount of taxes you might have to pay
If you choose to pay the taxes on your gain, you might be responsible for the following:
- Long term federal capital gains tax rate may be as high as 20%, depending on your income bracket.
- State tax can also add to the financial tax hit, depending on the State in which you live. For example, in California, an investor could possibly also pay up to 13.3% in income tax.
- Depreciation recapture is taxed at a flat rate of 25%, which can be quite significant if you’ve held and depreciated your investment property for a long period of time.
- Net Investment Income Tax (NIIT) applies to certain net investment income of investors that have income above the statutory threshold, at a rate of 3.8%.
Point #2: Opportunity cost of any amount you pay in taxes
When an investor pays taxes that could otherwise be deferred, they’re left with less capital that could otherwise be used for investment purposes that could generate more return for them.
Let’s use a simple example: Suppose that an investor sells an investment property for $1 million, and the total amount of taxes that they would owe on such sale is $350,000. That accredited investor then decides, for purposes of our example, that they will pay the taxes owed and take the $650,000 in cash remaining and invest it in some investment that pays 5% annual interest. That investor, based on our example, should make a return of $32,500 per year.
However, if that same investor had completed a 1031 exchange deferring all of their taxes and depreciation recapture, for example into a DST paying 5% annually, their annual return should be $50,000, a difference of $17,500. While the above is a simplified example, it helps illustrate the opportunity cost of paying the taxes rather completing a 1031 exchange.
Lastly, investors should note that if they pay their taxes the $350,000 in the above example is gone forever. If they were to do an exchange they would have deferred their taxes, the $350,000 would be able to generate potential income for them AND when the investor passes, his or her heirs would receive a full step up in basis thereby eliminating the $350,000 of capital gains taxes forever. So not only will the investor make $17,500 in income less per year but the investors estate would also lose $350,000 of principal. This math above is the very reason why so many investors choose to utilize the 1031 exchange as it is one of the most tax efficient strategies that real estate investors can utilize.
Before an investor decides to pay any owed taxes on the sale of their investment property rather than completing a 1031 exchange and deferring those taxes, they should thoroughly understand the financial implications as everybody’s unique situation is different, by consulting with their professional tax advisor, CPA and attorney.
Kay Properties is a national Delaware Statutory Trust (DST) investment firm. The www.kpi1031.com platform provides access to the marketplace of DSTs from over 25 different sponsor companies, custom DSTs only available to Kay clients, independent advice on DST sponsor companies, full due diligence and vetting on each DST (typically 20-40 DSTs) and a DST secondary market. Kay Properties team members collectively have over 115 years of real estate experience, are licensed in all 50 states, and have participated in over 15 Billion of DST 1031 investments.
This material does not constitute an offer to sell nor a solicitation of an offer to buy any security. Such offers can be made only by the confidential Private Placement Memorandum (the “Memorandum”). Please read the entire Memorandum paying special attention to the risk section prior investing. IRC Section 1031, IRC Section 1033 and IRC Section 721 are complex tax codes therefore you should consult your tax or legal professional for details regarding your situation. There are material risks associated with investing in real estate securities including illiquidity, vacancies, general market conditions and competition, lack of operating history, interest rate risks, general risks of owning/operating commercial and multifamily properties, financing risks, potential adverse tax consequences, general economic risks, development risks and long hold periods. There is a risk of loss of the entire investment principal. Past performance is not a guarantee of future results. Potential cash flow, potential returns and potential appreciation are not guaranteed. The above is not intended as tax or legal advice.
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