This is part four in my series on 1031 exchanges. Keep in mind that I’m using the 2015 rules for the calculation.
If the tax payer falls within the 10% or 15% marginal income tax brackets, then the long-term capital gains tax rate is 0%.
the 25%, 28%, 33%, or 35% marginal income tax brackets, the long-term capital gains tax rate is 15%.
the 39.6% marginal income tax bracket, the long-term capital gains tax rate is 20%.
In addition, the capital gains of high-income earners are subject to a net investment income tax of 3.8%, above and beyond that capital gains tax rate. Those rates kick in at $125,000 if the taxpayer is married filing separately, $200,000 if single or as a head of household, or at $250,000 if married filing jointly or a qualifying widow(er) with a dependent child. (Recaptured depreciation is taxed at a maximum of 25%.)
The tax savings versus a taxable sale comparison
1. Calculate Net Adjusted Basis
Original Purchase Price
+ Improvements _________________
– Depreciation _________________
= NET ADJUSTED BASIS
2. Calculate Capital Gain
Sales Price __________________
– Net Adjusted Basis _
– Cost of Sale __________________
= CAPITAL GAIN __________________
3. Calculate Capital Gain Tax DUE
Recaptured Depreciation (25%)
+ Federal Capital Gain (see above)
+ State Tax (when applicable)
= TOTAL TAX DUE __________________
4. Analyze Purchase without an Exchange
Sales Price Cost of Sale Loan Balances
= GROSS EQUITY ___________________
Capital Gain Taxes Due __
= NET EQUITY Net Equity X 4 = ___________________
5. Analyze Purchase with an Exchange
Capital Gain Taxes Due Gross Equity = Net Equity Gross Equity x 4 = ______________
One of the primary advantages of a 1031 exchange is not just the tax savings, but the purchasing power it can create. Using some leverage, the Exchanger can purchase two to three times more investment real estate for the replacement property.
Investors are shocked to find out that capital gains can be far high than the federal rate when you add state taxes. In California for example, capital gains are taxed at the earned income rate. Plus, depreciation taken over the ownership period is taxed at 25%, resulting in a sizable percentage of the profits to paying taxes. Under the 4th calculation, the net equity times three (assuming a 33% down payment) is the value of property you could purchase after paying all capital gain taxes.
Using a 1031 exchange allows the exchanger to defer all capital gains taxes allowing to use the entire proceeds of the relinquished property to acquire considerable more real estate as the replacement property(s)