How to Calculate Tax Liability When Selling Your Investment Property

Even in a thriving seller’s market, one aspect that concerns investment property owners is the burden of capital gains taxes. For instance, in California, owners of investment properties can face tax rates as high as 42.1% when selling their property. Given the substantial tax liability in many states, numerous investors are exploring tax-deferral strategies, such as utilizing a 1031 Exchange.

Comprehending Tax Liability

Tax Liability = Capital Gains Tax + Depreciation Recapture Tax

As an experienced 1031 Exchange professional, our primary task when assisting clients is to help them understand their tax liability. Tax liability stemming from the sale of investment real estate encompasses more than just the federal capital gains tax. It represents the total sum of taxes owed when an investment property is sold. Apart from Federal Capital Gains Tax (ranging from 15% to 20%), the property owner may also be subject to State Capital Gains Tax (ranging from 0% to 13.3%), Depreciation Recapture Tax (25%), and Net Investment Income Tax (3.8%).

Five Steps to Calculate Your Tax Liability

When estimating your tax liability after selling an asset, federal and state tax authorities consider the taxable gain rather than the gross proceeds from the property sale. To determine the total tax liability, follow these five steps:

Step 1: Estimate the Net Sales Proceeds

Begin by establishing the fair market value of the investment property or the listing price if you put the property on the market. There are various methods to calculate the sales price, but the two most common approaches are the income method and the comparable sales method.

• Income Method: Divide the current or projected net operating income (NOI) by the desired capitalization rate (cap rate).

• Comparable Sales Method: Assess value based on recent sales of comparable properties in the local area, considering factors like size and quality.

Smaller properties and single-family rentals usually rely on the comparable sales method, while larger properties use the net operating income to determine value. Many investors seek the assistance of an experienced broker to establish a justifiable sales price.

Step 2: Estimate the Tax Basis

Tax basis, or remaining basis, represents the total capital invested and capitalized in the asset, which includes the purchase price, closing costs, and capitalized improvements, minus the accumulated depreciation. To calculate the tax basis, consider the following example:

• Initial Purchase Price: $850,000
• Capital Improvements: $200,000
• Accumulated Depreciation: $750,000

Remaining Basis Calculation:

• Remaining Basis = Purchase Price + Improvements – Depreciation
• Remaining Basis = $850,000 + $200,000 – $750,000 = $300,000

Note that there are certain limitations regarding which items can be included in the tax basis. For instance, mortgage insurance premiums and routine maintenance costs are typically excluded. It is advisable to consult with a tax advisor to determine the current remaining basis of your property, taking into account adjustments for capital improvements and tax deductions.

Increasing the Tax Basis:

Property owners can increase their tax basis by making investments in the property through capitalized improvements. These improvements, such as a new kitchen, roof, or addition, contribute to increasing the investment in the property. When selling the property, these capitalized improvements are subtracted from the net sales proceeds to determine the property’s gain. While legal fees, management expenses, and small repairs are treated as operating expenses and not capitalized, capital improvements allow owners to increase the tax basis of the asset instead of deducting them as current-year operating expenses.

Decreasing the Tax Basis:

Owners of investment real estate that includes a building or structure need to decrease the property’s tax basis, which affects the calculation of the second form of gain known as “depreciation recapture.” The primary method to decrease the tax basis is through an annual depreciation deduction. This deduction is subtracted from the tax basis each year and is treated as a tax expense that offsets income. While depreciation reduces the tax basis and increases tax costs at sale, it reduces annual taxable income and lowers the income tax due during the ownership years.

It’s worth mentioning that annual depreciation is mandatory, and depreciation recapture is charged based on the total amount of available depreciation throughout the ownership period, regardless of whether depreciation expenses were recorded. Additionally, easements, certain insurance reimbursements, and other tax deductions like personal property deductions can also contribute to decreasing the tax basis.

Step 3: Calculate Taxable Gain

The taxable gain represents the profit from the sale of an asset. It is derived by subtracting the original tax basis (pre-depreciation) from the net sales proceeds. Tax authorities like the IRS and Franchise Tax Board utilize the taxable gain figure to determine the capital gains tax.

Example Calculation:

• Original Tax Basis: $1,050,000
• Net Proceeds from Sale: $3,250,000

Taxable Gain Calculation:

• Taxable Gain = Net Sale Proceeds – Original Tax Basis
• Taxable Gain = $3,250,000 – $1,050,000 = $2,200,000

The second part of the tax liability is calculated based on the amount of accumulated depreciation taken throughout the ownership period, referred to as accumulated depreciation. In this example, the accumulated depreciation is $750,000.

Step 4: Determine Your Filing Status

Your capital gains tax rate is determined by factors such as your income, tax filing status, the state where you pay income taxes, and the location of the property being sold. Various tax authorities, including the IRS, state governments, and some local governments, impose capital gains taxes on investment property sales, thereby impacting the overall tax rate and increasing your tax obligation.

Your capital gains tax rate is determined by factors such as your income, tax filing status, the state where you pay income taxes, and the location of the property being sold. Various tax authorities, including the IRS, state governments, and some local governments, impose capital gains taxes on investment property sales, thereby impacting the overall tax rate and increasing your tax obligation.

At the federal level, the capital gains tax rate is as follows:

• 0%: Income below $40,000 (single) or $80,000 (married filing jointly)
• 15%: Income between $40,001-$441,450 (single) or $80,001-$496,600 (married filing jointly)
• 20%: Income above $441,451 (single) or $496,601 (married filing jointly)

Additionally, most state tax authorities also levy a capital gains tax, with rates ranging from 0% to 13.3%. California stands at the top with a 13.3% capital gains tax rate, while states like Texas, Washington, and Florida do not impose state capital gains taxes.

Step 5: Calculate the Capital Gains Tax

The capital gains tax is calculated based on the taxable gain, considering the tax rates determined by your income and filing status. There are four main categories of property tax: federal capital gains tax, state and local capital gains tax, depreciation recapture tax, and net investment tax.

Federal and State Capital Gains Taxes Calculation:

In the example above, a California property owner with a taxable gain of $2,200,000 would owe:

• Federal Capital Gains Tax: 20% of $2,200,000 = $440,000
• State Capital Gains Tax: 13.3% of $2,200,000 = $292,600
• Total Capital Gains Tax: $732,600

Individuals with significant investment and rental income may also be subject to an additional 3.8% net investment tax, which is part of the Affordable Care Act and is added on top of the capital gains rate. Thus, the total capital gains tax bill in California would be 37.1%, or $816,200, in this example. Want to estimate how much you may own in capital gains taxes? Try our capital gains calculator.

Depreciation Recapture Tax Calculation:

In addition to capital gains taxes, investors must pay depreciation recapture tax. Depreciation deductions are taken annually to offset rental income. When selling the asset at a profit, the investor is required to repay those deductions, which is known as depreciation recapture.

Depreciation Recapture Tax Rates:

• Federal: 25% of accumulated depreciation
• State: Up to 13.3%
• Net Investment Income Tax: Additional 3.8%

In the example with $750,000 of accumulated depreciation, the depreciation recapture tax could be as high as $315,750.

Deferring Capital Gains Tax with a 1031 Exchange

Real estate investors have a valuable opportunity to defer, reduce, and potentially eliminate capital gains taxes through a strategy called a 1031 Exchange, also known as a “like-kind” exchange. This type of exchange, authorized under Section 1031 of the U.S. Internal Revenue Code, allows real estate investors to defer their tax liability when selling an investment property. To defer capital gains taxes, investors must reinvest the proceeds from the sale into like-kind investment property that has equal or greater value.

The term “like-kind” refers to any real estate that is of the same nature or class, rather than the same quality or property type. Essentially, this means that investors can exchange one investment real estate asset for another, as long as it falls under the category of like-kind property. It’s important to note that primary residences don’t qualify for a 1031 Exchange; only investment properties do.

The Rules for a 1031 Exchange

A 1031 Exchange is a powerful tool for deferring capital gains, depreciation recapture, and net investment income taxes after selling an asset. However, these exchanges can be complex transactions, and it is crucial to comply with the rules set forth by the IRS. Failure to adhere to these rules can result in a failed exchange or a partial exchange, leading to potential tax liabilities. Before proceeding with a 1031 Exchange, investors should familiarize themselves with the following 1031 exchange rules:

• Set up the exchange before the sale: The 1031 Exchange must be established before the sale of the investment property takes place. The necessary arrangements and documentation should be prepared in advance.

• Exchange for like-kind property: The property being exchanged must be of “like-kind” to qualify for a 1031 Exchange. This means the property should be of the same nature or class, regardless of quality or property type. For example, an investor can exchange an apartment building for a retail property.

• Equal or greater value: The replacement property acquired in the exchange must have an equal or greater value than the relinquished property. Any cash or debt reduction received, known as “boot,” may trigger capital gains tax liability.

• Same taxpayer: The taxpayer who sold the relinquished property and acquired the replacement property must be the same individual or entity. The taxpayer cannot transfer the ownership to another party.

• Qualified Intermediary: The 1031 Exchange must be facilitated by a Qualified Intermediary (QI), an independent entity that holds the sales proceeds and ensures compliance.

• Capital gains and depreciation recapture tax: If there is any boot received, such as cash or a reduction in debt, the property owner may be subject to paying capital gains tax and depreciation recapture tax on that portion.

• Identification period: The property owner has 45 days from the sale date to identify potential replacement properties. The identification should be in writing and follow specific identification rule.

• Exchange completion period: The property owner has 180 days from the sale date to complete the exchange by acquiring the replacement property. The replacement property must be received within this timeframe.Understanding and following these rules is crucial for a successful 1031 Exchange. It is recommended to consult with a qualified tax advisor and/or someone who specializes in 1031 Exchanges to better ensure compliance and strive to maximize the benefits of the exchange.

Improving Cash Flow Potential with a 1031 Exchange

In addition to the tax savings, a 1031 Exchange offers the potential to enhance cash flow and appreciation by allowing the reinvestment of proceeds. Let’s consider the example where the investor’s total tax liability is $1,131,950. If the post-tax proceeds of $2,118,050 were reinvested and earned a 5% return, it would generate an annual income of $105,903.

However, by opting for a 1031 Exchange, the investor would have $3,250,000 available for reinvestment. Assuming the same 5% return, the exchanged proceeds would generate an annual cash flow of $162,500. This represents a significant difference in cash flow potential, exceeding $56,500. This is one of the primary benefits of 1031 Exchanges – the ability to keep all your equity working for you, generating income and potential appreciation.

By deferring capital gains tax and reinvesting the full sales proceeds into a new property, investors have the opportunity to leverage a larger amount of capital, potentially resulting in higher cash flow and increased investment returns. This enhanced cash flow potential is a key advantage of utilizing a 1031 Exchange as part of a strategic real estate investment plan.