Consider the case of Ron and Maggie1, a couple who bought a modest apartment complex in California a decade ago for $1,500,000. They contributed $500,000 of their personal funds and secured the remaining $1,000,000 with a mortgage.
| Cash Equity Paid by Investor | $500,000 |
| Mortgage Financing | $1,000,000 |
| Purchase Price | $1,500,000 |
Over the course of several years, the adjusted basis of the property owned by Ron and Maggie could resemble the following:
| Purchase Price | $1,500,000 |
| PLUS: Acquisition Costs (Example: Title Insurance) | $10,000 |
| PLUS: Capital Improvements (Example: New Roof) | $65,000 |
| LESS: Depreciation Taken During Ownership | $(400,000) |
| LESS: Deferred Capital Gains | $- |
| EQUALS: Adjusted Tax Basis at Sale | $1,175,000 |
Ron and Maggie are contemplating selling their property, which they believe could be sold for $2,850,000. If they factor $50,000 in closing costs, their “realized gain” may look like this:
Realized Gain
| Sales Price of Relinquished Property | $2,850,000 |
| LESS: Closing Costs on Relinquished Property | $(50,000) |
| EQUALS: Net Selling Price | $2,800,000 |
| LESS: Adjusted Tax Basis (From Step 1) | $(1,175,000) |
| EQUALS: Realized Gain | $1,625,000 |
Keep in mind that the actual gain differs from cash obtained through the sale. Assuming the mortgage has been reduced to $800,000, the net cash received could be represented as follows:
Net Cash Received
| Sales Price | $2,850,000 |
| LESS: Balance on Mortgage to Pay Off | $(800,000) |
| LESS: Closing Costs on Relinquished Property | $(50,000) |
| EQUALS: Net Cash Received on Sale | $2,000,000 |
Next, Ron and Maggie estimate their potential tax liability from the property sale. With an assumed Realized Gain of $1,625,000 (refer to the earlier calculation), the sale is expected to put the couple in the highest tax bracket, and their possible tax liabilities could look like this:
| Federal Capital Gains Tax1 | 20.0% | $245,000 |
| Federal Tax on Depreciation Recapture2 | 25.0% | $100,000 |
| Affordable Care Act Surtax | 3.8% | $61,750 |
| State Capital Gains Tax (CA)3 | 12.3% | $199,875 |
| TAXES DUE (Effective Tax Rate)4 | 37.3% | $606,625 |
(1) Federal Capital Gains equal to Realized Gain less depreciation taken multiplied by the applicable rate.
(2) Based on amount of depreciation taken during ownership of the property. In this example, the amount is based on $400,000 of depreciation taken.
(3) Rate varies by state. Example assumes California.
(4) Effective tax rate depicted as a percentage of Realized Gain of $1,625,000 (from Step 2).
Through the use of a 1031 exchange, Ron and Maggie could potentially defer 37.3% in taxes and preserve all of the profit from the sale of their property. This means they would potentially have more than $600,000 in additional equity to reinvest!
| With 1031 Exchange | Without 1031 Exchange | |
| Net Proceeds from Sale | $2,000,000 | $2,000,000 |
| LESS: Taxes Paid | $- | $(606,625) |
| EQUALS: Equity Available to Reinvest | $2,000,000 | $1,393,375 |
How Much Time do I Have?
There are two important deadlines; if either are missed, taxes will be owed. The IRS does not grant extensions on these deadlines. You have 45-days from the date you sell your property to identify potential Replacement Property(ies). You have 180-days from the date you sell your property to purchase your Replacement Property(ies).
What MUST I Buy?
In order to defer all of your capital gains taxes, the Replacement Property must have a purchase price and mortgage balance equal to or greater than the Relinquished Property being sold. Investors are not required to reinvest 100% of their sales proceeds in replacement property. This is known as a “Partial Exchange” and the portion the exchange proceeds that are not reinvested are referred to as “Boot” and are subject to taxes.
Ron and Maggie believe their property can be sold for $2,850,000. Assuming the mortgage balance will be $800,000, their evaluation of a suitable Replacement Property would look like this:
| Replacement Property | Relinquished Property | |||
| Purchase Price | $3,975,000 | > OR = | Sale Price: | $2,850,000 |
| LESS: New Mortgage: | 2,000,000 | > OR = | LESS: Mortgage Bal.: | 800,000 |
| ADD: Closing Costs** | 25,000 | LESS: Closing Costs: | 50,000 | |
| EQUALS: Proceeds | $2,000,000 | > OR = | EQUALS: Proceeds: | $2,000,000 |
Closing Costs are considered part of your equity
What MAY I Buy?
In general, any type of real estate investment property type may qualify for an exchange, except your primary residence. The IRS considers all “Investment Properties” to be “Like-Kind.”
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Hypothetical example(s) are for illustrative purposes only and are not intended to represent the past or future performance of any specific investment.
Investing in alternative assets involves higher risks than traditional investments and is suitable only for sophisticated investors. Alternative investments are often sold by prospectus that discloses all risks, fees, and expenses. They are not tax efficient and an investor should consult with his/her tax advisor prior to investing. Alternative investments have higher fees than traditional investments and they may also be highly leveraged and engage in speculative investment techniques, which can magnify the potential for investment loss or gain and should not be deemed a complete investment program. The value of the investment may fall as well as rise and investors may get back less than they invested.
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