Analyze the Benefits Before Selling
The benefits of 1031 exchanges can be significant for taxpayers who own investment property. Taxpayers have the potential to defer all capital gain taxes, depreciation recapture, the net investment income tax( NIIT), and state taxes. If the requirements of a valid 1031 exchange are met, capital gain recognition will be deferred until the taxpayer chooses to recognize it.
A married couple filing jointly sells an investment property in North Carolina for $1,000,000 (net of closing costs) with no debt. The couple originally purchased the property for $400,000. Seventy-five percent, or $300,000 of the initial purchase price, was allocated to the building and has been fully depreciated. The capital gain is approximately $900,000 (today’s sales price of $1,000,000 minus the net adjusted basis of $100,000). This is the only source of the couple’s investment income. The couple’s modified adjusted gross income is $1,400,000 (which includes income from other sources and capital gain from this sale) for purposes of calculating the net investment income tax. The couple will be taxed at 25% for their prior depreciation deductions taken, 20% federal capital gains tax rate, the 3.8% net investment income tax and they will be in the 5.25% North Carolina state tax bracket.
|Today's Net Sales Price (after closing costs) Less taxes owed||$1,000,000|
|$300,000 depreciation recapture @ 25%||= $75,000|
|$600,000 federal capital gain @ 20%||= $120,000|
|$900,000 net investment income tax @ 3.8%||= $34,200|
|$900,000 state tax @ 5.25%||= $47,250|
|Total taxes owed||= $276,450|
|After-Tax Net Equity
$1,000,000 - $276,450
|1031 Exchange Gross Equity||= $1,000,000|
|Reinvestment of Equity with 50% Leverage
*not all exchanges will carry leverage
|Taxable Sale: Net Equity x 21||= $1,447,100|
|1031 Exchange: Gross Equity x 21||= $2,000,000|
The North Carolina taxpayers in this example could potentially purchase a replacement property that is worth approximately $1.4 million more by performing a 1031 exchange instead of a taxable sale. Exchanges provide the opportunity to preserve equity, increase cash flow from larger replacement properties, and enable taxpayers to maximize return on investment.
1 If the investor takes the equity from the sale or 1031 Exchange and levers it up, they could take the $1M and put it into one DST that has 50% leverage you will get a $2M property, or the investor could take the Net Equity of $723,550 and get a bank loan of $723,550 to get a property value of $1,447,100.
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