Real estate owners in the final stages of selling an investment property can face substantial tax liabilities. Upon closing, owners may be straddled with federal capital gains, state income and depreciation recapture taxes. Any potential profits could be considerably eroded -- but there are ways to make the most of your pending exit transaction.
Below we’ll outline some available options, including one way you can potentially defer paying any tax at all on the sale of your real property.
Owning real estate brings benefits and challenges. Landlords who have decided to sell their properties for whatever reason should be concerned with one thing upon exit: eliminating taxes. Why? Because the math of paying federal gains tax favors the government and not the investor.
Paying 35 percent taxes on the sale of your investment property -- 30 percent federal capital gains tax and 5 percent state tax -- requires you to realize at least a 54 percent gain just to offset your tax liabilities. Far easier said than done, since real property rarely appreciates that significantly over shorter hold times of five or fewer years.
Capital gains aren’t your only tax burden, either. If you claimed depreciation deductions on your investment property, you’ll have to pay that money back as well. When you sell, you are required to report to the IRS the difference in the asset’s basis and its sale price. That profit is recaptured at 25 percent for properties purchased after May 7, 1997 (28 percent prior).
These numbers can change a great deal depending on your tax bracket, return expectations, how long you hold the asset, short- and long-term capital gains taxes, and other considerations. However, it does give you a baseline assumption of the hefty financial liability you’ll likely face upon exit if you opt to just cash out.
Federal capital gains and depreciation recapture taxes can negatively impact investor returns. However, by creating a long-term investment strategy, there are ways investors can retain their investment capital gains and potentially realize a more lucrative future.
A 1031 exchange allows you to roll the proceeds from the sale of an investment property into another similar or like-kind asset of equal or greater value. Investors who complete a 1031 exchange can successfully defer paying capital gains taxes on profits of the relinquished asset.
The term “like-kind” has a wide interpretation in commercial real estate. Replacement assets can be of the same class or of similar quality. They can be in different geographical regions as well. Savvy investors use this range of options to craft well-diversified portfolios of multiple asset classes in different markets.
There are strict IRS guidelines for completing a 1031 exchange. You have 45 days to identify up to three replacement assets, and 180 days to close on one or more of them. Investors considering this option prior to close of sale on their investment properties need to start planning as soon as possible to ensure a successful exchange.
There is a quicker alternative, though.
With a DST, you aren’t purchasing a property outright. Instead, you purchase fractional shares of investment-grade properties through a sponsor. DSTs are considered securities under federal securities laws, so they are eligible for 1031 exchanges.
If you’re nearing the final stages of your sale, a DST 1031 exchange offers a much quicker pathway to completion for several reasons:
Swapping properties via 1031 like-kind exchanges until you pass has great merit when you consider your heirs can receive a one-time step-up in basis that can effectively wipe out all capital gains liabilities.
If you keep rolling properties over through 1031 exchanges, you’ll never pay capital gains or depreciation recapture taxes. You can also potentially preserve more wealth and leave a greater financial legacy for your heirs.
Make the most of your pending sale by discussing these alternatives with qualified tax and accountancy professionals.