By Christopher Miller, MBA

Specialized Wealth Management

I think it is valuable to periodically feature a “1031 Exchanges – Back to Basics” article to reach investors who may not be familiar with this powerful investment tool. The 1031 Exchange is a procedure that the IRS allows us real estate investors to use that will defer (potentially forever) taxes and keep all of our equity invested – giving us the potential to both earn higher income and see greater appreciation over our lifetimes: potentially multiple millions of dollars worth!

Taxes Due From a “Standard” Property Sale

Let’s say that our investor bought 8 Units in Orange County back in 1985 for $350,000 and sold it this year for $3.5 million for a gain of $3,150,000. How big will that tax bill be?

First, the IRS now has a sliding scale for Capital Gains. 20 years ago, the rate was “just” 15%. Today, there are three Capital Gains brackets: Zero percent up to a $96,700 gain, 15% for any additional gain up to $600,050, and then 20% of any gain above that amount. For our investor, that bill totals $585,492.

Next, California will want their “share” of the gain at their graduated tax scale that runs between 1% and 13.3%. The total Capital Gains tax paid to California will be $376,165.

Since the beginning of “Obamacare,” the Affordable Care Act has charged 3.8% on investment income. 3.8% of our $3,150,000 Capital Gain is $119,700.

Our investor has finished paying taxes on his gains, but he’s not done yet – next he needs to pay a Depreciation Recapture tax on his Accumulated Depreciation – the sum of all the depreciation deductions he took over the years. Let’s assume that he used an 80% Improvements to 20% Land Value ratio for his calculations. His total accumulated depreciation is therefore $280,000. (80% of his original purchase price.)

The IRS charges a 25% rate on accumulated depreciation; for a total of $70,000. Once again, California will charge their tax on the same scale as before, and will want $25,634.

From our investor’s $3,150,000 gain, he will pay a total of $961,658 of Capital Gains taxes plus $199,700 for Obamacare. For his Depreciation Recapture, he’ll pay an additional $95,634 – for a total tax bill from this sale of $1,176,992. This leaves us with an after-tax gain of $1,973,008.

These Taxes Will Take a Huge Bite From Your Investments

Our investor, pre-sale, had $3,500,000 of equity providing potential income and growth for him. If he sells and pays his taxes, he’ll likely find it harder to create similar income and growth from the $2,323,008 he has left. $2,323,008 paying 5% annual income would provide $116,150 compared to $175,000 if our investor put all $3,500,000 to work. Similarly, his after-tax money appreciating at 3% per year could give us $3,121,928 of value in 10 years, while his full amount appreciating at 3% would be $4,700,000 in 2035.

Our investor paid $1,176,992 of taxes while missing the potential for both $58,850 of annual income in year one, and $1,578,072 of additional gains from holding 10 more years.

The Solution – a 1031 Exchange Will Keep 100% of Your Equity Invested for 100% of the Income and Growth Potential

With a 1031 Exchange, our investor can put all his proceeds into a qualified replacement property and defer those taxes – potentially forever. By keeping all of his equity invested, he can enjoy the full income and growth potential from his life’s work and then pass the full amount on to his heirs.

“Potentially Forever” Tax Savings

Although a 1031 Exchange will only defer your taxes until the next time you sell property, an investor can then orchestrate another 1031 Exchange to defer those taxes again. When he dies, his heir will receive what the IRS calls a Stepped Up Basis. While he is in “taxpayer heaven,” his heirs will mark the value of his assets to the day of his death for tax purposes. Three benefits come from this:

1. All the capital gains and depreciation recapture taxes he has been deferring throughout his lifetime will disappear.
2. With the “Stepped Up Basis,” his heir’s tax basis in the property becomes it’s value on the date of his death. They could sell the property the very next day and pay zero Capital Gains tax.
3. Since the property’s tax basis is “marked to market,” his heirs can then begin taking annual depreciation deductions using the current market value of the property – for even more tax savings!

The Real Estate Investor’s Most Valuable Tool – a 1031 Exchange

Stock investments in a tax-free account such as an IRAor 401(k) can grow much faster because the account’s principal is not eroded by taxes every time something is sold. A 1031 Exchange allows us real estate investors to apply the same principal to our portfolios – and receive the same benefits. Next month, I will walk you through the nuts and bolts of how such an exchange works. If you have any questions, please call my office toll-free at (877) 313-1868.

Christopher Miller is a Managing Director with Specialized Wealth Management and specializes in tax-advantaged investments including 1031 replacement properties. Chris’ real estate experience includes work in commercial appraisal, in institutional acquisitions for a national real estate syndicator and as an advisor helping clients through over five hundred twenty five 1031 Exchanges. Chris has been featured as an expert in several industry publications and on television and earned an undergraduate business degree and an MBA emphasizing Real Estate Finance from the University of Southern California. Chris began his real estate career in 1998. Call him toll-free at (877) 313 – 1868.

Securities offered through Emerson Equity LLC, member FINRA/SIPC. Emerson Equity LLC and Specialized Wealth Management are not affiliated. All investing involves risk. Always discuss potential investments with your tax and/or investment professional prior to investing.