AT WHAT RATE WILL THE TAXPAYER BE TAXED IF THEY DON'T DO A SECTION 1031 EXCHANGE?

For those of us old fogies (I think that is a word) we would call the possible tax on the sale of an investment property held for the proper time limit, long term Capital Gains Tax.  Today, most practitioners just call it Capital Gains Tax.

What is Capital Gains Tax?  It's the tax that IRS assesses on investment property and is figured out as follows:  Tax on the difference between what the investment property is sold for and it's "adjusted basis".  "Adjusted Basis" is the original purchase price of the investment property plus any capital improvements you made to the property after you purchased it.  These capital improvements of course increase your "Adjusted Basis".  For example:  Taxpayer purchased an investment property 3 years ago for $600,000.00.  The taxpayer put capital improvements (added on a room) to the property at a cost of $125,000.00.  The "Adjusted Basis" on that property will be $725,000 ($600,000 original purchase price + $125,000 capital improvements).   If the taxpayer sold the property for $900,000 they would have made a long term capital gains profit of $175,000($900,000-$725,000). 

The present federal tax on long term capital gains is at 15%.  So if the taxpayer did not exercise their right to consummate a Section 1031 tax deferred exchange and instead decided to pay their tax, they would pay $26,250($175,000 x 15% = $26,250) in long term Capital Gains tax.

But there is more to the story - the taxpayer took some Depreciation on that investment property.  Congress in it's infinite wisdom, a number of years ago, said that investment property is falling apart a certain per centage a year.  It's at a different rate for investment condominiums than it is let's say for an office building.  But in either case, the taxpayer has been receiving a Depreciation tax deduction each tax year of their ownership.   

For our example, let's just say that the taxpayer took $28,000 in Depreciation deductions while they owned the property.  This Depreciation tax deduction would be subtracted from the taxpayer's Adjusted Basis.  In our example, we had an Adjusted Basis of $725,000, less the $28,000(Depreciation taken) leaving a new Adjusted Basis of $697,000.  The taxpayer will be taxed on the amount of Depreciation taken at the rate of 25%, it's called a Depreciation Recapture Tax. 

So in our example we had $28,000 of Depreciation taken and the Depreciation Recapture tax on the investment property would be $7,000($28,000 x 25% = $7,000).  We now have a total tax due of $33,250 ($26,250 long term Capital Gains Tax + $7,000 Depreciation Recapture Tax = $33,250).  But that's not all, because in some states they have an individual state tax which must also be added to the mix.  I realize this is a complicated subject, all the more reason why you the taxpayer should make sure you discuss your situation with your financial/tax advisor and hire an experienced Qualified Intermediary to handle the Section 1031 tax deferred exchange. 

Most investors would prefer not to have to pay the above mentioned taxes (in our example the tax was $33,250--not including any possible state taxes).  So how do I get away with not having to pay any of the above taxes in the future?  Do a Section 1031 exchange and read our next blog.