In the height of the real estate boom from 2002 to 2006, doing a 1031 Tax Deferred Exchange was such a common occurrence. We think about it a lot more in a rising market. However, even though the Outer Banks market is still in recovery mode, a 1031 exchange may still be a very necessary process, even without massive profits from actual sales price. All due to one word…depreciation.
Specifically, the way it works is the gain, not the profit or equity, from the sale of your investment/beach/second home could be subject to Federal and State taxes. Also subject to federal taxes at the time of sale is the depreciation taken over several years on the property. That amount is taxed at a whopping 25%!!! This could really sneak up on you!
How to Determine a Potential Capital Gain when
Selling Without an Exchange
Step 1: Calculate the Basis
$300,000 Original Purchase Price
+ $ 50,000 Improvements that haven’t been expensed in a previous tax year
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$ 60,000 Depreciation taken
$290,000 Net Adjusted Basis
Step 2: Calculate Capital Gain
$475,000 Sales Price today
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$290,000 Net Adjusted Basis
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$ 25,000 Cost of Sale (commissions, transfer tax, fees, etc)
$160,000 Realized Capital Gain
Step 3: Calculate Capital Gain Tax Due
$15,000 Recaptured Depreciation = 25% x Depreciation taken
$24,000 Federal Capital Gain Tax at 15% x Realized Capital Gain
$32,000 Federal Capital Gain Tax at 20% x Realized Capital Gain
Please Note:
*Income less than $39,375, the long-term capital gains tax rate is zero
* 15% if income is less than $434,550 20% if income is more than $434,550
*This does not include any potential state capital gain taxes
What can you do if you want to sell and avoid paying Federal Capital Gains Tax?
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You can defer the federal tax by performing a 1031 exchange for a property of equal or more value than the property you are exchanging, and acquiring the same. debt/mortgage equal to or exceeding the debt on the relinquished property.
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You can move into the home and make it a primary residence for 2 of the last 5 years and roll over up to $250,000 if single and $500,000 if married.
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You can reduce tax liability by doing some major improvements that are not expensed in any previous tax year.
This is an overview of the process. For more detailed information on your specific tax implications contact a tax professional. To find out more about doing a 1031 Tax Deferred Exchange we recommend Realty Exchange Corporation at www.1031.us.