By Mary Kay Kennedy, National Operations Manager
First American Exchange Company
With falling property values and the availability of other losses to offset gains, there is a perception in the marketplace that it is not worthwhile to do a 1031 exchange anymore. While it is true that capital gains rates are relatively low and the amount of gain from appreciation is less than it was before the recession, there are some less obvious factors that will influence the amount of tax that is due when selling investment property and may make an exchange desirable.
Tax on Gain from Appreciation in Value
The most obvious tax liability is the federal capital gains tax, at a maximum 15% rate, on the “gain,” which in basic terms is the difference between the sales price and the price that the investor originally paid for the property. This rate was lowered from 20% to 15% as a part of the Jobs and Growth Tax Relief Reconciliation Act of 2003, which was extended and is currently scheduled to expire at the end of 2012. Therefore, even if Congress takes no action, the federal capital gains rate will go up to 20% in 2013.
Recapture of Depreciation
In addition to paying capital gains tax on appreciation, an investor must pay tax at a higher rate (25%) on the depreciation that was taken during the investor’s ownership of the property. This means that even if there is no appreciation in value between the time the property is acquired and it is sold, there will still be tax due because of recapture of depreciation.
Gain from Prior Exchanges
Each time an investor completes a 1031 exchange, the tax on the gain is deferred and is not due until the replacement property is sold. If the investor does another exchange at that time, the obligation to pay tax on the gain is deferred again. If the investor eventually decides to cash out instead of doing an exchange, at that time the tax that was never paid is due. Because of this, it is important to consider gain from prior exchanges when determining how much tax will be due on a disposition.
In some states you must also pay state tax on appreciation and recapture of depreciation. This state tax can be at a rate as high as 11%. Although Internal Revenue Code Section 1031 is a federal statute, most states incorporate it as-is into their tax structure, so you can defer both federal and state tax when doing a 1031 exchange.
3.8% “Medicare Tax”
Starting on January 1, 2013, there will be yet another reason to consider doing a 1031 exchange when selling property. On that date, high income taxpayers will also need to pay an additional 3.8% tax on all “unearned” income, which is generally defined as interest, dividends, rents and capital gains, including capital gains from the sale of real estate. The tax is sometimes referred to as the Medicare Tax because the proceeds of the tax are earmarked for the Medicare Trust Fund.
The tax is not assessed against all taxpayers, however. It is only imposed to the extent the taxpayer’s adjusted gross income is higher than $200,000 for an individual or $250,000 for a married couple. A single taxpayer with adjusted gross income of less than $200,000 will not have to pay this tax, even if the taxpayer sells property and needs to pay capital gains tax on the sale.
Although the tax on unearned income will not be in effect until 2013, investors should be made aware of it in order to plan future transactions. There has not been a great deal of information about this tax because it is new, but based on the language of the statute, investors should be able to defer the tax by doing a 1031 exchange.
As you plan to sell your properties in 2012 and 2013, you should take into account the tax that will be due not only on appreciation in value but also on recapture of depreciation. The tax may include federal and state taxes, plus in 2013 a tax on unearned income. Having a complete understanding of what tax will be due will give you a clear idea of what you will receive in net proceeds and allow you to decide whether it makes sense to do an exchange.