Selling Your Rental?

Step 5: Calculate the Capital Gains Tax

Capital gains taxes are applied to the taxable gain based on the tax rate determined by your income and filing status, and the bill can be significant. There are four property tax categories: federal capital gains taxes, state and local tax, depreciation recapture, and net investment tax – which can overlap one another.

The federal capital gain tax and state taxes are calculated at the investor's tax rate on the taxable capital gain (i.e. appreciation). In our example above, a California property owner with a taxable gain of $2,200,000 would owe 20% in federal capital gains tax and 13.3% in state capital gains tax, amounting to $732,600 in tax. Individuals with significant investment and rental income may also have an additional 3.8% net investment tax—included as part of the Affordable Care Act—added on top of the capital gains rate. This brings the total capital gains bill in California to 37.1% or $816,200 in the example above. This example is unique to properties and taxpayers located in California, which has the country's highest tax rate paid on capital gains.

In addition to capital gains taxes, investors will also pay depreciation recapture. Investors take a depreciation deduction on their annual taxes to offset rental income. The depreciation deduction not only decreases the investor's annual tax liability but also decreases the remaining tax basis for the property. Once you sell the asset for a profit, you must pay back those deductions. This is depreciation recapture. The tax rate on depreciation recapture is a flat rate of 25% at the Federal level, can also include up to 13.3% state income tax, and also be subject to net investment income tax for an additional 3.8%. While capital gains tax is based on the taxable gain, depreciation recapture is calculated based on the accumulated depreciation during the investor's ownership. Based on $750,000 of accumulated depreciation, the depreciation recapture tax in this scenario could be as high as $315,750 or 42.1%.

The Rules for 1031 Exchange

A 1031 Exchange can be an excellent tool to defer capital gains, depreciation recapture, and net investment income taxes otherwise due from the sale of investment real estate, but they can also be complicated transactions. While 1031 Exchanges are flexible in the number of strategies that can be implemented, the rules put forward by the IRS are not flexible. Failure to adhere to IRS rules can result in either a failed Exchange, in which the entire tax liability is due or a Partial Exchange, in which a portion of the tax liability is due (generally the most expensive portion). Prior to the sale of investment property, investors considering an exchange should become familiar with how 1031 Exchanges work and the following primary rules:

• The Exchange must be set up before a sale occurs

• The Exchange must be for like-kind property

• The Exchange replacement property must be of equal or greater value

• The property owner must pay capital gains and/or depreciation recapture tax on "boot"

• The taxpayer that sold and acquired the Exchange property must be the same

• The Exchanger has 45 days following the sale to identify replacement properties

• The Exchanger has 180 days following the sale to complete the Exchange

Improving Potential for Cash Flow with a 1031 Exchange*

A 1031 Exchange can improve the potential for cash flow and appreciation by allowing all of the proceeds to be reinvested. In our example, the investor's total tax liability would be $1,131,950. If the post-tax proceeds of $2,118,050 were reinvested and earned a 5% return, this would generate $105,903 in annual income. However, by performing a 1031 Exchange, the investor would have $3,250,000 to reinvest. At the same return of 5%, the exchange proceeds would generate an annual cash flow of $162,500. The difference in cash flow potential of over $56,500 represents one of the primary benefits of 1031 Exchanges – the ability to keep all your equity working for you to generate income and appreciation.

Find Out if a 1031 Exchange is Right for You

If you plan to sell your investment property and want to understand your tax deferral options, contact Real Estate Transition Solutions to speak with a licensed 1031 Exchange Advisor. We offer complimentary consultations that can be done over the phone, via video conference, or in person at one of our offices. To schedule your consultation, call 206-502-4862 or visit us at www. re-transition.com/rhawa.

Chief Exchange Strategist, Austin Bowlin, CPA, leads Real Estate Transition Solutions' (RETS) team of licensed 1031 Exchange advisors & analysts and provides consultation on tax liability, deferral strategies, legal entity structuring, co-ownership arrangements, 1031 replacement property options, and Delaware Statutory Trust investments. RETS is a consulting firm specializing in tax-deferred 1031

Exchange strategies and Delaware Statutory Trust investment property. For over 26 years, RETS has helped investment property owners perform successful 1031 Exchanges by developing and implementing well-planned, tax-efficient transition plans carefully designed to meet their objectives. Our team of licensed 1031 Exchange Advisors will guide you through the entire process, including help selecting and acquiring passive management replacement properties best suited to meet your objectives. To learn more about Real Estate Transition Solutions, call (206) 502-4862 or visit us at re-transition.com/rhawa.

Important Information

The information herein has been prepared for educational purposes only and does not constitute an offer to purchase or sell securitized real estate investments. Such offers are only made through the sponsor's Private Placement Memorandum (PPM), which is solely available to accredited investors and accredited entities. Case studies and examples are for illustrative purposes and are not representative of future results. There are risks associated with investing in real estate properties, including, but not limited to, loss of entire investment principal, declining market values, tenant vacancies, and illiquidity. Because investor situations and objectives vary, this information is not intended to indicate suitability for any particular investor. This material is not to be interpreted as tax or legal advice. Please speak with your own tax and legal advisors for advice/guidance regarding your situation. DST 1031 properties are only available to accredited investors (generally described as having a net worth of over $1 million exclusive of primary residence) and accredited entities only. If you are unsure if you are an accredited investor and/or an accredited entity, please verify with your CPA and Attorney. Securities are offered through Aurora Securities, Inc. (ASI), member FINRA/SIPC. Advisory services are offered through Secure Asset Management, LLC (SAM), a registered investment advisor. ASI and SAM are affiliated companies. Real Estate Transition Solutions (RETS) is independent of ASI and SAM.

* Potential cash flows/returns/appreciation are not guaranteed and could be lower than anticipated.

Source: IRS.gov