Capital gains are the profits generated from the sale of an asset. It applies to both financial assets, such as stocks and bonds, as well as tangible assets, such as investment property.
Capital gains are calculated as the sales price of an asset less the investor’s basis in that asset. For financial assets, basis typically equals the original purchase price. However, with investment property, an investor’s basis is adjusted over the holding period for improvements made to the property and depreciation allowance taken during ownership.
Depreciation allowance is a benefit to investors during ownership as it reduces taxable income, allowing investors to keep a greater share of the property’s income. However, when the property is sold, the investor’s basis has been decreased, resulting in higher capital gains exposure.
Fortunately, real estate offers investors the opportunity to defer capital gains through a 1031 tax-deferred exchange. Similar to a 401k, a 1031 exchange allows investors to defer gains by rolling over proceeds and reinvesting in investment properties. A 1031 exchange maximizes equity available for reinvestment, potentially resulting in significantly higher cash flow and wealth accumulation compared to paying taxes.
Investment Property Wealth Management® encompasses exit planning, a critical but often overlooked component of capital preservation, retirement planning and estate planning.