SELLING YOUR RENTAL? Calculate Your 1031 Exchange Tax Savings in 5 Steps

Austin Bowlin, CPA – Partner & Chief Exchange Strategist | Real Estate Transition Solutions | Vendor Member

Paying taxes on the sale of an investment property can be expensive, especially if you live in a high-tax state. Not only are you responsible for Federal Capital Gains Tax (15% – 20%) and Depreciation Recapture Tax (25%), but you may also have to pay State Capital Gains Tax (0-13.3%), and Net Investment Income Tax (3.8%).

As a Washington property owner, you can pay up to 28.8% in taxes when selling your investment property. If you have plans to sell in 2023, a 1031 Exchange can be an excellent strategy to avoid paying a substantial tax bill.

What is a 1031 Exchange?

A 1031 Exchange, also known as a "like-kind" Exchange, gets its name from Section 1031 of the U.S. Internal Revenue Code. By performing a 1031 Exchange, you can sell investment real estate without paying tax if you reinvest the sales proceeds into like-kind investment property of equal or greater value and adhere to IRC 1031 rules and timing requirements. And, because the IRS defines "like-kind" as any real estate of the same nature or class (not of the same quality or property type), you can exchange any real estate held for business or investment purposes for other real estate held for business or investment purposes, regardless of the property type.

Calculate Your 1031 Exchange Tax Savings: 5 Easy Steps

The tax liability on the sale of investment real estate is not just about federal capital gains tax – it is the total aggregate amount of tax owed when selling an investment property.

As a 1031 Exchange advisory firm, one of the first things we do when working with clients is to help them understand their tax liability and discuss tax-deferral options.

Federal and state tax authorities calculate the amount you owe based on the taxable gain (capital gain i.e. appreciation and depreciation recapture), not the gross proceeds from the sale of the property. To estimate the total tax liability from 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. With the income method, divide the current or estimated net operating income (“NOI”) by the target capitalization rate (“cap rate”). With the comparable sales method, an investor determines a value based on recent sales of similar local properties, both in terms of size and quality. Smaller properties and single-family rentals typically rely on the comparable sales method, while larger properties rely on net operating income to determine value. Most investors work with an experienced broker to set a supportable sales price. 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.

Step 2: Estimate the Tax Basis

The remaining tax basis, also known as the remaining basis, is the total capital an owner has invested and capitalized in the asset, including the purchase price, closing costs, and capitalized improvements less the accumulated depreciation taken over the ownership period. 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 you can include in a 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 minor repairs, are not capitalized and instead treated as operating expenses which are deductible in the year they are expended. 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 capital gain.

• While some of these costs are intrinsic to real estate investment, like escrow fees, others are flexible. For example, 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 deducting in the current year as operating expenses.

• Decreasing the Tax Basis: Owners of investment real estate that include a building or structure must also lower 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 original tax basis on an annual basis and 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 depreciation recapture 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. In addition, easements, some insurance reimbursements, and other tax deductions, like personal property deductions, can also decrease your tax basis.

Step 3: Calculate Capital 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 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 are $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 details above, 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 property's location will determine your capital gains tax rate. The IRS, most state governments, and some local municipalities collect a tax on both the capital gain and depreciation recapture from the sale of investment property, increasing the total tax rate due and thus increasing your tax bill.

At the federal level, the capital gains tax rate is 0% for investors with an annual income (including gains resulting from asset sales) less than $44,625 (single) / $89,250 (married filing jointly); 15% for investors with an annual income from $44,626 - $492,300 (single) / $89,251 to $553,850 (married filing jointly); and 20% for investors with an annual income above $492,301 (single) / $553,851 (married filing jointly). Most state tax authorities collect income tax rates on capital gains as well. The state tax rate ranges from 0% to 13.3%. California is at the top of the list with a 13.3% tax rate, while some states, like Texas, Washington, and Florida, do not collect state income taxes.

Our Annual Spring Workshop + Tradeshow will be held at the enchanting urban oasis: Cedarbrook Lodge , conveniently located near SeaTac. This is your best opportunity to gather the latest insights from across the industry in one day for your rental business.

Saturday, May 13 9 am – 3 pm

• Discover numerous skilled service providers at the tradeshow.

• Select from 12 expert-led educational breakout sessions with attorneys and industry professionals.

• Indulge in gourmet lunch and happy hour. Parking included.

Tickets go onsale March 3!

Register@RHAwa.org/swts

For more information, contact Chloe Moser: cmoser@RHAwa.org