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Understanding Capital Gains Tax Liability Without a 1031 Exchange

Updated: May 6

When selling a property, capital gains tax becomes a significant consideration for investors. The decision to utilize a 1031 tax deferred exchange can have a substantial impact on the amount of tax owed. Let's explore how capital gains tax works without the benefits of a 1031 exchange.

Capital Gains Tax Basics:

Capital gains tax is a levy imposed on the profit made from the sale of an asset, such as real estate. The gain is calculated by subtracting the property's purchase price (adjusted basis) from the selling price. The tax is then applied to this gain. 

Other factors, such as, capital improvements, expenses and depreciation would be considered as well. It’s best to work with your accountant to understand the full capital gain on the sale of your investment real estate.

Standard Capital Gains Tax Rates:

Without the protection of a 1031 exchange, the capital gains tax rates typically vary based on how long the property was held, but a good rule of thumb is probably 25% between federal and state taxes. 

- Short-term Gains (held for less than a year): Taxed at the individual's ordinary income tax rate, which can be significantly higher.

- Long-term Gains (held for more than a year): Taxed at preferential rates, usually lower than the ordinary income tax rate.

Net Investment Income Tax:

In addition to regular capital gains tax, high-income earners may be subject to the Net Investment Income Tax (NIIT). This 3.8% tax is applied to the lesser of net investment income or the amount by which adjusted gross income exceeds a specific threshold.

The Impact of a 1031 Exchange:

A 1031 exchange allows investors to defer 100% of capital gains tax by reinvesting the proceeds from the sale into a like-kind property. This deferral strategy enables investors to preserve more capital for future investments and grow your real estate portfolio faster.

Example Scenario:

Let's consider a scenario where an investor sells a property without utilizing a 1031 exchange:

- Original Purchase Price: $300,000

- Selling Price: $500,000

- Capital Gain: $200,000

Without a 1031 exchange, if this gain falls under long-term capital gains, the investor would owe tax based on the applicable rate. If you used 25% as your rule of thumb, then you’d owe $50,000 in taxes. That’s a lot of money to hand over to Uncle Sam when you can legally defer that tax and instead buy a bigger and better cash-flowing property.

Understanding the potential capital gains tax liability is crucial for real estate investors. While a 1031 exchange offers a valuable opportunity for deferring taxes, investors should carefully weigh their options based on individual circumstances and investment goals. Consultation with a tax professional and a qualified 1031 intermediary like 1031 Pros is advisable to navigate the complexities of capital gains tax and explore strategies to optimize tax outcomes.

Visit or call 916-212-6900 today to talk with a live representative about how you can utilize a Reverse 1031 exchange to avoid taxes on your next investment real estate transaction.

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