Even in the most robust seller’s market, there is one thing that gives an investment property owner pause: capital gains taxes. And as a California investment property owner, your tax liability on the sale of investment property can be substantial – as much as 42.1% – driving many investors to explore tax-deferral strategies like a 1031 Exchange.
A Closer Look at Tax Liability
As a licensed 1031 Exchange Advisor, one of the first things we do when working with a client is to help them understand their tax liability. Tax liability from the sale of investment real estate is not just about federal capital gains tax – it is the total aggregate amount of tax owed when an investment property is sold. Not only are you responsible for Federal Capital Gains Tax (15% – 20%), but you may also have to pay State Capital Gains Tax (0-13.3%), Depreciation Recapture Tax (25%), and Net Investment Income Tax (3.8%).
How to Calculate Tax Liability
Federal & state tax authorities calculate the amount you owe based on the taxable gain, not the gross proceeds from the sale of the property. To estimate the total tax liability after the sale of an asset, follow these five steps:
Step 1: Estimate the Net Sales Proceeds
Start by determining the fair market value of the investment property or the list price if you brought the property to market. There are several ways to calculate the sales price, but the most popular are the income method and the comparable sale method. Smaller properties and single-family rentals typically rely on the comparable sales method, while larger properties rely on net operating income to determine value. For example, let’s assume a comparison of similar local properties indicates a property may sell for $3,500,000 with $250,000 in deductible selling costs such as brokerage costs, title, escrow, and excise tax (if applicable). In this scenario, the net sales proceeds would be $3,250,000. Importantly, the net sales proceeds do not consider any loan balances paid off at closing.
Step 2: Estimate the Tax Basis
Tax basis, also known as remaining basis, is the total capital that an owner has invested and capitalized in the investment property, including the purchase price, closing costs, and capitalized improvements minus the accumulated depreciation. For example, if you purchased the property for $850,000, invested $200,000 in capital improvements and have $750,000 in depreciation, your remaining basis is $300,000. There are some limitations to the items that you can include in the tax basis. Mortgage insurance premiums and routine maintenance costs are examples of items that are not included. A tax advisor can help to determine your property’s current remaining basis, which can be adjusted based on capital improvements and tax deductions.
- Increasing the Tax Basis: Property owners will increase their tax basis anytime they invest money into the property with capitalized improvements—such as a new kitchen, roof, or even an addition, as well as financing expenses. Expenses paid to operate the property, like legal fees, management expenses, and small repairs are not capitalized and instead are treated as operating expenses. Capitalized improvements increase your investment in the property and are deducted from the net sales proceeds at the time of the sale to arrive at the property’s gain. While some of these costs are intrinsic to real estate investment, like escrow fees, others are flexible. A new roof, an upgrade to the kitchen, or adding a pool are capital improvements that have a wide range of costs, giving the owner some flexibility in the amount they can increase the tax basis of the asset versus deduct in the current year as an operating expense.
- Decreasing the Tax Basis: Owners of investment real estate that include a building or structure must also decrease the property’s tax basis, ultimately increasing the figure used to calculate the second form of gain referred to as “depreciation recapture”. The most common way to decrease the tax basis is through an annual depreciation deduction. The deduction is subtracted from the tax basis on an annual basis to be treated as a tax expense offsetting income which is then recaptured at the time of sale. While it might seem unexpected to decrease your tax basis and eventually increase your tax costs, the depreciation deduction reduces an investor’s annual taxable income and thus income tax due during the years of ownership. Note that annual depreciation is not optional. Investors will be charged for depreciation recapture on the aggregate amount of available depreciation throughout the period of ownership regardless of whether they recorded depreciation expense. Easements, some insurance reimbursements, and other tax deductions, like personal property deductions, can also decrease your tax basis.
Step 3: Calculate Taxable Gain
The taxable gain is the realized return or profit from the sale of an asset, or, in other words, it is the net sales proceeds less the original tax basis, pre-depreciation. Tax authorities like the IRS and Franchise Tax Board use the taxable gain figure to determine the capital gains tax. To calculate the taxable gain, subtract the original tax basis from the net sale proceeds. Using the earlier example, if your original tax basis is $1,050,000 and the net proceeds from the sale of the property is $3,250,000, your taxable gain is $2,200,000. The second part of the tax liability is calculated based on the amount of depreciation available to take over the period of ownership – referred to as accumulated depreciation. Based on the above scenario, this amount is $750,000.
Step 4: Determine Your Filing Status
Your income, tax filing status, the state where you pay income taxes, and the location of your investment property will determine your capital gains tax rate. The IRS, most state governments, and some local governments collect a capital gains tax on the sale of an investment property, compounding the rate and increasing your tax bill. At the federal level, the capital gains tax rate is 0% for investors with an annual income (including the gain resulting from asset sales) less than $40,000 per year; 15% for investors with an annual income from $40,001 to $441,450; and 20% for investors with an annual income above $441,451. Most state tax authorities collect a capital gains tax as well. The state tax rate ranges from 0% to 13.3% with California at the top of the list at 13.3%.
Step 5: Calculate the Capital Gains Tax
Capital gains taxes are applied to the taxable gain based on the tax rate determined by your income and filing status, and the bill can be significant. There are four property tax categories: federal capital gains taxes, state and local capital gains tax, depreciation recapture, and net investment tax. The federal and state capital gains taxes are calculated at the investor’s tax rate on the taxable gain. In our example above, a California property owner with a taxable gain of $2,200,000 would owe 20% in federal capital gains tax and 13.3% in state capital gains tax amounting to $732,600 in total capital gains taxes. Individuals with significant investment and rental income may also have an additional 3.8% net investment tax—included as part of the Affordable Care Act—added on top of the capital gains rate. This brings the total capital gains bill in California to 37.1% or $816,200 on the example above. This example is unique to properties and taxpayers located in California, which has the highest capital gains tax rate in the country.
In addition to capital gains taxes, real estate investors will also pay depreciation recapture. Investors take a depreciation deduction on their annual taxes to offset rental income. The depreciation deduction not only decreases the investor’s annual tax liability but also decreases the remaining tax basis for the property. Once you sell the asset for a profit, you must pay back those deductions. This is depreciation recapture. The rate of tax on depreciation recapture is a flat rate of 25% at the federal level, can also include up to 13.3% state income tax, and be subject to net investment income tax for an additional 3.8%. While capital gains tax is based on the taxable gain, depreciation recapture is calculated based on the accumulated depreciation during the investor’s ownership. Based on $750,000 of accumulated depreciation, the depreciation recapture tax in this scenario could be as high as $315,750.
Deferring Capital Gains Tax with a 1031 Exchange
By performing a 1031 Exchange, investment property owners can defer, reduce and even eliminate paying capital gains, depreciation recapture, and net investment income taxes on the sale of investment property. And while 1031 Exchanges are flexible in the number of strategies that can be implemented, the IRS’s rules to qualify are not flexible. Failure to adhere to IRS rules can result in either a failed Exchange, in which the entire tax liability is due, or a Partial Exchange, in which a portion of the tax liability is due (generally the most expensive portion). To learn more about 1031 Exchanges, visit our website at www.re-transition.com/aoausa and download our FREE guide, “Understanding 1031 Exchanges”.
Improving Potential for Cash Flow with a 1031 Exchange
In addition to tax savings, a 1031 Exchange can improve the potential for cash-flow and appreciation by allowing the proceeds to be reinvested. In our example, the investor’s total tax liability would be $1,131,950. If the post-tax proceeds of $2,118,050 were reinvested and earning a 5% return, this would generate $105,903 in annual income. However, by performing a 1031 Exchange, the investor would have $3,250,000 to reinvest. At the same return of 5%, the exchange proceeds would generate an annual cash flow of $162,500. Although potential cash flow/returns/appreciation is never guaranteed and could be lower than anticipated, the difference in cash flow potential of $56,500 represents one of the primary benefits of 1031 Exchanges – the ability to keep all your equity working for you to generate income and appreciation.
Learn More About 1031 Exchanges
If you have plans to sell your highly-appreciated investment property and would like to learn more about tax-deferred 1031 Exchanges and Delaware Statutory Trusts, contact Real Estate Transition Solutions and speak to a licensed 1031 Exchange Advisor. We offer complimentary consultations that can be done over the phone, via web conference, or in person at one of our offices. Call us at 415-691-6525, email [email protected] or visit www.re-transition.com.
Austin Bowlin, CPA is a Partner at Real Estate Transition Solutions and leads the firm’s team of licensed 1031 Exchange Advisors & Analysts. Austin advises on tax liability, deferral strategies, legal entity structuring, co-ownership arrangements, 1031 Exchange options, and Delaware Statutory Trusts. To learn more about Real Estate Transition Solutions, visit our website at www.re-transition.com.
This is for informational purposes only, does not constitute as individual investment advice, and should not be relied upon as tax or legal advice. Please consult the appropriate professional regarding your individual circumstance. Because investor situations and objectives vary this information is not intended to indicate suitability for any individual investor. There are material risks associated with investing in DST properties and real estate securities including liquidity, tenant vacancies, general market conditions and competition, lack of operating history, interest rate risks, the risk of new supply coming to market and softening rental rates, general risks of owning/operating commercial and multifamily properties, short term leases associated with multi-family properties, financing risks, potentially adverse tax consequences, general economic risks, development risks, long hold periods, and potential loss of the entire investment principal. Potential cash flows/returns/appreciation are not guaranteed and could be lower than anticipated. Diversification does not guarantee a profit or protect against a loss in a declining market. It is a method used to help manage investment risk. DST 1031 properties are only available to accredited investors (typically defined as having a $1 million net worth excluding primary residence or $200,000 income individually/$300,000 jointly of the last three years; or have an active Series 7, Series 82, or Series 65. Individuals holding a Series 66 do not fall under this definition) and accredited entities only. If you are unsure if you are an accredited investor and/or an accredited entity, please verify with your CPA and Attorney. This article was collectively authored by Austin Bowlin and a paid third-party firm. Real Estate Transition Solutions offers securities through Concorde Investment Services, LLC (CIS), member FINRA/SIPC. Advisory services through Concorde Asset Management, LLC (CAM), an SEC-registered investment adviser. Real Estate Transition Solutions is independent of CIS and CAM.
Sources: https://www.irs.gov/taxtopics/tc409, and https://taxfoundation.org/state-individual-income-tax-rates-and-brackets-for-2020/