Real estate investors in many cases do not understand that the sale of depreciated property has a hidden tax. The much-heralded Tax Relief Act of 2003 created a 15% myth, which has added a larger hidden surprise. Aimed at stimulating economic growth, the Tax Relief Act lowered the capital gains rate to 15% effective for sales after 5/5/03. Nevertheless, the capital gains rate change is not as simple as it may seem. Many taxpayers believe all their long-term capital gains will be taxed at 15%. Nevertheless the recapture of depreciation is still taxed at 25%. Lets do a simple example to illustrated this:
A rental unit purchased in 1997 for $75,000 is depreciated and later sold for $150,000. Its adjusted basis at the time of sale is $50,000 creating a gain of $100,000. The gain of $75,000 from appreciation is taxed at 15% while the remaining depreciation of $25,000 will be taxed at 25%. If the taxpayer is in 15% tax bracket he will pay 5% on the $75,000 but will be forced to pay 15% on the depreciation. In addition, most states apply taxes rates over and above the Federal rates.
The general rule is that a real estate investor pays taxes on the increase in value of the property and on the depreciation deduction he took while he owned the property. How does an investor avoid this and use all the funds from the sale to reinvest in another property. The answer lies in Internal Revenue Code Section 1031. Section 1031 states:
No gain or loss shall be recognized if property held for productive
use in a trade or business or for investment is exchanged solely for property of like-kind.
“Like-kind” refers to the nature, character, or class of the property, not to its grade or quality. Provided the property is initially acquired and held for either business or investment purposes, it can qualify as suitable replacement property. An exchange of real estate for real estate is an exchange of “like-kind” property. It does not matter where the real estate is located, except for foreign locations, or whether it is improved or not. Raw land can be exchanged for a rental home, an apartment complex for a shopping center, or rental houses for an office building. The use of the property is a key factor in determining the tax treatment. The tax code lists specific items that are not “like-kind”. Stocks, bonds, and interests in partnerships are some items considered not “like-kinds”.
If an investor sold fully depreciated property with a gain of $200,000, they would pay taxes of $70,000 - federal recapture at 25% and state recapture at 10%. In this case the investor would only have $130,000 to reinvest. Assuming a down payment of 20%, he could buy a property worth $650,000. If our investor got savvy and used Section 1031; he now has the full $200,000. He can now buy a property worth $1,000,000 and increased his net worth by $350,000.
Prior to 1979, most exchanges involved situations were both properties closed on the same day. Since 1979, delayed exchanges have become common practice. Delayed exchanges are characterized by time constraints, which has lead to the use of qualified intermediaries. The property to be received in the exchange must be identified in a written agreement within 45 days after the transferred property is surrendered. The property in the exchange must be received on or before the earlier of 180 days after the transferred property is surrendered or the due date (including extensions) of the tax return for the year in which the exchange takes place.
Another consideration in 1031 exchanges is “boot”. “Boot” is a term used to describe “non like-kind” property received in an exchange. Cash, notes, personal property, and reduction in mortgage (debt relief) are all examples of “boot’ and are subject to tax. Most transactions can be restructured to help reduce or eliminate “boot”. To avoid “boot”, an exchanger must trade across or up in both equity and mortgage.
Although the postponement of tax from a tax-free exchange is really an interest free loan from the government, one disadvantage is present. The basis in the old property is transferred to the new property. Therefore, if you own a property with a basis of $25,000, now valued at $50,000 and exchange it for a property worth $50,000 your basis is $25,000 not $50,000. If you sell the second property, you are still liable for the recapture tax in amount of $6,250 (25% x $25,000).
“Tax Tips” are the opinions of Executive Accounting Solutions, which is not a substitute for individual accounting, tax, and professional services since individual situations vary.