Owning investment property means much more than maximizing cash flow through rent growth and occupancy. Owning investment property means managing the taxes that come with it, whether that be in the form of taxable income or capital gains. In this article, we’ll discuss three key differences between exchanging, selling, or inheriting investment property, and the tax implications that come with each scenario.
Continually Exchanging Investment Property
If you acquired investment property through a 1031 exchange and want to execute another exchange to continually defer your taxes, you simply need to follow the 1031 rules again. This means the replacement property needs to be of “like-kind” property, and that you must follow the same 45-day identification and 180-day closing timelines.
For tax purposes, the basis in your replacement property may be different than if you acquired the property in a non-1031 exchange. Basis plays a vital role in determining how much annual depreciation you can write off against taxable income.
One question that may arise is - what if I ran out of basis on the relinquished property, but still want to take advantage of the tax benefits of depreciation on the replacement property? Improvements with a useful life of more than one year can add to your replacement property’s basis. Also, if you are using debt to acquire greater property value in your replacement property than what was just sold, your depreciable basis may increase after the exchange.
In regards to taxes, you remain in a tax-deferred state until you sell (rather than exchange) your 1031 property.
Selling An Investment Property Outright
At some point in time, some investment property owners will want to exit the 1031 exchange merry-go-round. This can happen for a variety of reasons that include needing liquidity or wanting to limit one’s exposure to real estate altogether. When the decision has been made to sell outright, rather than 1031 exchange into another property, what will your tax situation look like?
Other than your federal and state tax rates, your tax liability will be determined by the adjusted tax basis of your investment property. Adjusted tax basis is simply your basis (cost basis if acquired outright or carryover basis if acquired through an exchange), plus any improvements that were made, less any deductions for depreciation.
You may also be liable for depreciation recapture on the disposition of the property. As depreciation is taken on the property each year (claimed on Schedule E), it reduces the taxable income derived from the property. Once the property is disposed of, however, the IRS recaptures some of the depreciation at a maximum rate of 25%. As an example, if you have $25,000 in accumulated depreciation expense and a total of $90,000 in gains, you are taxed at 25% on the $25,000 and 0% to 20% on $65,000 in gains depending on your tax bracket.
Inheriting An Investment Property
If you pass away and your heirs inherit a 1031 exchange property from you, the deferred taxes of the property are basically eliminated. Your heirs do not have to pay your taxes. This is because your heirs will inherit the property with a step-up in basis, which means the property’s new basis will be whatever the IRS deems to be its “fair market value.” Since your capital gain is the difference between the sale price and your adjusted basis in the property, if your heirs immediately sell the property at fair market value, there will be no gain to be taxed.
Whether you are exchanging, selling, or inheriting investment property, it is always important to be aware of what your tax situation looks like. Understanding the strategies available to you to reduce and defer your capital gain taxes is the first step towards building Tax-Optimized wealth.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.
Realized does not offer legal or tax advice. As such, this information should not be used as a substitute for consultation with professional accounting, tax, legal or other competent advisers. Before making any decision or taking any action, you should consult with a qualified professional.
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