A 1031 Exchange offers the opportunity to defer taxation on up to four different types of taxes. The taxes included are the federal capital gains tax, depreciation recapture tax, state tax, and net investment income tax. It is important to recognize that the use of an exchange does not avoid these taxes but allows for them to be deferred down the road.

Capital Gain

A provision within the tax code allows for the deferment of capital gains taxes by enabling the exchange of property without immediate recognition of gains or losses. Capital gains tax applies to profits from asset sales, including real estate, stocks, and businesses, with different tax rates based on income brackets and asset holding periods. Short-term gains are taxed as ordinary income, while long-term gains have more favorable rates. As mentioned previously, 1031 exchanges do not eliminate taxes, as they become due upon a taxable sale. So what qualifies as a taxable sale? This means the replacement property involved in a previous exchange was sold without being sheltered under a new exchange. 

Calculating Capital Gains Tax:

When capital gain is generated, the property has sold for more than what it was purchased for. The purchase price is commonly referred to as “cost basis” in the exchange industry and is crucial in determining if a 1031 exchange is the right fit for you. For instance, selling for less than your cost basis is identified as capital loss and typically will not require 1031 exchange treatment. The Internal Revenue Code utilizes the asset’s “adjusted basis” to determine these gains or losses. They verify the claimed adjusted basis by beginning with the original cost basis, then adding the expenses of capital improvements and subtracting any depreciation claimed. It’s important to recognize that depreciation applies solely to improvements made to real estate, as the land value does not depreciate. Calculate your estimated capital gains tax using our calculator.

Depreciation Recapture

A tax provision implemented a depreciation recapture tax which is generated from taxpayers being mandated to pay taxes on the depreciation claimed for a depreciable asset during their ownership period. This tax liability arises upon the sale of the asset. If you sold business or investment property without utilizing a 1031 exchange, you likely need to report the depreciation recapture tax owed on your tax return for the year of the sale.To report depreciation recapture tax on your annual return, be sure to consult with your tax advisor.

Assets subject to depreciation recapture tax include real estate, vehicles, equipment, intangible assets like patents, copyrights, rental properties, and partnership interests. Depreciation recapture tax can be deferred through a 1031 exchange which assists in managing tax liabilities on the sale of qualifying real estate.

Calculating Depreciation Recapture Tax

To calculate depreciation recapture tax, first determine the annual allowable depreciation based on whether the property is residential or commercial. Then, calculate the total depreciable value by subtracting the land value from the original purchase price and adding the cost of improvements. Next, divide the total depreciable value by the appropriate depreciation schedule (27.5 for residential or 39 for commercial) to find the annual allowable depreciation.

Once you have the annual allowable depreciation, multiply it by the total years you have owned the property to get the accumulated depreciation. Finally, multiply the accumulated depreciation by the depreciation recapture tax rate of 25% to find the total depreciation recapture tax owed to the IRS. This tax, along with any capital gains tax, will be due without a 1031 exchange.

Net Investment Income Tax

One of the taxes among the four subject to 1031 treatment is the Net Investment Income Tax (NIIT). It is imposed on net investment income, which includes interest, dividends, capital gains, rent, and royalties, among other sources, as outlined in IRC Section 1411. This tax, at a rate of 3.8%, applies to individuals, estates, and trusts with income above specified thresholds.

To calculate NIIT, taxpayers determine their modified adjusted gross income (MAGI), which is adjusted gross income increased by certain deductions or exclusions. If MAGI exceeds $200,000 for single filers or $250,000 for married couples filing jointly, NIIT applies.

For example, a single filer with $180,000 in wages and $15,000 in dividends and capital gains has a MAGI of $195,000, below the $200,000 threshold, thus not subject to NIIT. Conversely, a single filer with $180,000 in wages and $90,000 from a passive partnership interest, resulting in a MAGI of $270,000, exceeds the threshold by $70,000, leading to an NIIT of $2,660 ($70,000 x 3.8%).

Taxpayers are advised to seek guidance from tax and legal advisors when considering a 1031 exchange. Additionally, engaging a Qualified Intermediary and utilizing tax calculators for temporary estimates is recommended for managing exchange transactions effectively. By proactively addressing deferrable taxes, you can better manage your tax liabilities and enhance your overall financial planning strategies.

The information presented is for information purposes and is not intended as investment, legal, tax or compliance advice. Land 1031 does not offer or sell investments or provide investment, legal, or tax advice.

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