Capital gains and recaptured depreciation can be determined in three easy steps. If you are considering a 1031 exchange, the taxes due represent the value of the 1031 exchange or what the IRS will consider deferred if equal or greater replacement property is acquired. It could be considered an interest free loan because the gain is not paid to the IRS but used towards the replacement property.
Step Number One
The first step is adding three numbers together to determine the adjusted basis.
Original purchase price + capital improvements – depreciation taken = adjusted basis
Step Number Two
Sales price – adj basis – selling expenses = realized gain
Step Number Three
Recaptured depreciation (depreciation taken * 25%) =
Federal capital gain (Realized gain – depreciation) * 15% =
State capital gain (Realized gain – depreciation) * __% if applicable =
Add these numbers together and you have determined the tax due. If you initiate a 1031 exchange, this value is deferred gain until the replacement property is sold. Another 1031 exchange can be used to defer the gain and recaptured on the replacement property, exchanging as many times as needed. There is no limit to the number of times you can use a 1031 exchange.
Conclusion
Now that the tax triggered by the sale is known, be sure the the net equity and retired debt (if any) on the old or relinquished property will be equal to or greater in the replacement property. If you want to pull out cash tax free, consider a post exchange refinance once the replacement property closes. If you remove cash at the closing of the old property it will be taxable.
The next step is to confirm your numbers with your accountant and decide to initiate a 1031 exchange.
Under Section 1031 of the Internal Revenue Code, investors may defer capital gains tax realized on the sale or exchange of property if the property is held for business or investment purposes and is like kind. Strictly speaking, Section 1031 is not reserved for real estate; however, it is most frequently used in the transfer of one real estate property for another. To better understand a 1031, there are a few things of which to be aware.
