Photograph by Kathy De La Torre
During a seminar, Debra Patterson, vice president at First Guaranty Exchange in San Jose, explains how to calculate a real estate investor's taxable gain.
Tax bite delayed by using exchange
By Debra Patterson
The previous article covered the general requirements of a 1031 tax-deferred exchange and established the general parameters that an investor would follow to achieve a successful exchange. However, a question that often precedes this topic is: "Why should I do a 1031 tax-deferred exchange?"
It's a good question and fortunately there are many good answers. Contrary to what most people may think, a 1031 tax-deferred exchange is as easy as a sale and purchase, except the money the investor would pay in capital gain taxes is available to purchase more real estate. Many investors don't realize that they are in a perfect position to take advantage of this tremendous benefit. The numerous other advantages of an exchange, include preservation of equity, leverage, diversification, consolidation/management relief and increased cash flow/income.
Preservation of Equity
A properly structured exchange provides real estate investors with the opportunity to defer 100 percent of both federal and state capital gain taxes (in most states). This essentially equals an interest-free, no-term loan on taxes due until the property is sold for cash. Most often, the capital gain taxes can be deferred indefinitely, because many investors continue to exchange one property for another, using the preserved equity to dramatically increase the value of their real estate investments with each exchange.
Further, an exchange not only defers the tax on appreciation, but also on the depreciation taken on the property. (Since depreciation is taken as a tax deduction on real property, it must be "recaptured" when the property is sold). Because an investor is taxed at an even higher tax rate on recaptured depreciation, the equity preserved becomes very valuable. The following illustrates this benefit:
Tom and Mary Smith purchased an investment property for $100,000 in 1987. They made $20,000 of capital improvements to the property, and depreciated it a total of $35,000. The property will sell today for $500,000.
Original Cost: 100,000
Plus Capital Improvements: 20,000
120,000
Less Depreciation: (35,000)
Equals Adjusted Basis: 85,000
Sales Price: 500,000
Less Adjusted Basis: (85,000)
415,000
Less Cost of Sale: (40,000)
Equals Capital Gain: 375,000
Assuming a 28% tax bracket +
35,000 of depreciation taxed @ 25%: 8,750
340,000 of appreciation taxed @ 20%: 68,000
375,000 of gain taxed @
9.3% for California: 34,875
TOTAL TAXES DUE: $111,625
By simply performing a 1031 exchange, this investor could save $111, 625 in taxes, and use the savings to continue building wealth by investing in real property.
Leverage
Most commercial lenders will loan up to 75 percent of the value of a property. Many investors use the 1031 tax-deferred exchange to enhance this benefit by exchanging from a high equity property to a more valuable property and using that equity as a down payment.
Diversification
A 1031 tax-deferred exchange also allows an investor to diversify by exchanging one property for several, but this isn't the only type of diversification. For example:
An investor interested in diversifying his investment portfolio from residential rental units to retail, could exchange his three duplexes for one large retail strip center.
An investor could diversify geographically and take advantage of a new growth area, by exchanging raw land in Lake Tahoe for an apartment building in Salt Lake City.
Consolidation/ Management Relief
The opposite of diversification, a 1031 tax-deferred exchange allows an investor to exchange several properties for one. Many of today's investors own several properties. However, more isn't always better. The on-going maintenance and management of what can be a far-reaching group of properties can often lead to increased expenses, and increased headaches. Through a 1031 tax-deferred exchange, an investor can eliminate these worries. Exchanging several single family rentals for a single apartment complex with a resident manager is a good example of this strategy: the investor will have less property to manage, decreased operating expenses and, perhaps most significantly, more time and peace of mind.
Increased Cash Flow/Income
An investor can increase both cash flow and overall income through a 1031 tax deferred exchange. Because of versatility when exchanging properties, an investor can exchange a vacant piece of land that generates no cash flow or depreciation benefits for a commercial building that does. Using leverage to exchange a small property for a larger one accomplishes the same purpose: a larger property produces more cash flow and provides greater depreciation benefits, which, therefore, increases an investor's return on investment.
With April 15 just around the corner, it's a good time to focus on the benefits and advantages of tax-deferred exchanges as a way to save, while increasing your real estate investments.
Saratoga, California Since 1955
