In a perfect world, buying low and selling high would work great. It’s a simple concept — just capture the spread in prices between the property you’re selling and the one you’re buying, right? The problem here is that the real world is always more complex. There’s a lot more to factor in before a true profit can be projected. In this article, we’ll look at the various components that decrease profits. Knowing this will help in coming up with a more accurate potential profit picture.
How Taxes And Depreciation Recapture Drag On Profits
Taxes and depreciation recapture are always sitting on the sidelines, waiting to pounce on real estate investors. The moment you consider selling, both will rear their head. Let’s look at an example to fully appreciate the impact of these two costs.
$400,000 — purchase price
$500,000 — sale price
The above home is held for five years. The absolute gain is $100,000. In this example, we don’t include maintenance costs. Depreciation is taken each year for up to 27.5 years. That’s about $400,000 / 27.5 or $14,545 each year for five years, resulting in a total depreciation of $72,725.
Depreciation recapture is based on the cost basis. We are recapturing depreciation on real property, which is called a Section 1250. The adjusted cost basis is $400,000 - $72,725 = $327,275. The realized gain is $500,000 - $327,275 = $172,725. The capital gain on the property is $172,725 - $72,725 = $100,000.
We can now begin factoring taxes in. We’ll assume a 32% tax bracket and capital gains rate of 15%. Depreciation recapture is limited to 25%. The calculation for depreciation recapture is:
0.15 x $100,000 = $15,000
0.25 x $72,725 = $18,181
$33,181 is the total depreciation recapture amount and taxed at the ordinary tax rate. Without depreciation recapture and taxes, we don’t get an accurate picture of any potential profit.
1031 Exchange To The Rescue?
A 1031 exchange provides tax deferral on gains. Instead of spending the proceeds on taxes, you can put it toward another investment property. That sounds great, but again, the real world has other plans.
A 1031 exchange must be completed within 180 days, and any potential replacement property must be identified within 45 days. Regarding any potential arbitrage between the selling of one property and buying of the next, 45 days doesn’t provide for any. You are basically buying back into the market you just sold out of.
Does that mean a 1031 exchange is not worth it? Of course not. The purpose of a 1031 exchange is all about tax deferral, not market arbitrage. Anyone who wants to utilize pure market arbitrage may want to consider a different strategy instead of a 1031 exchange.
Buying low and selling high, in general, is a good strategy to follow. Just make sure to bring taxes and depreciation recapture back into any profit projections. A 1031 exchange doesn’t really do anything for a buy low, sell high strategy. Since there are only 45 days available to identify a potential property, there isn’t enough time to arbitrage between the relinquished and replacement properties. A 1031 exchange should be looked at as a tax deferral strategy only.
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