CAPITAL GAINS, SECTION 125O PROPERTY, AND DEPRECIATION RECAPTURE
Your two primary concerns when you sell your investment real estate are the Capital gains tax on the sale of your Section 1250 Property, which is your real estate investment property, plus the Depreciation Recapture.
You can avoid both by doing a Section 1031 Like Kind Exchange.
Section 1250 Capital Gains, and Depreciation Recapture Tax can eat up a large part of your profits.
And those profits represents money that you could be investing in additional real estate.
Look at Free Money to see how this works.
In this article I will explain everything you need to know about:
* section 1250 property,
* straight-line depreciation,
* accelerated depreciation,
* bonus depreciation,
* depreciation recapture, and
* how to use Section 1031 to keep all of your profit, tax-deferred, and reinvest it.
If you are not familiar with any of the terms, check out our Dictionary.
You should also review the 1031 Exchange Rules.
And take a look at About to see my qualifications for making this presentation.
CAPITAL GAINS TAX SCENARIO
The easiest, best, and quickest way to explain a concept is to use real numbers and real people.
So this is our scenario, and don’t be overwhelmed, because we’ll go through these one-by-one so that you will understand (you are about to become one of the smartest people in the room):
:: Alan Adams bought a Duplex ten years ago for $200,000 cash.
:: He assigned $20,000 to the value of the land, and $180,000 to the building.
:: He began claiming Depreciation on the building.
:: He spent $30,000 for two garages, and began claiming Depreciation on them.
:: He spent $20,000 for furniture, and began claiming Depreciation on it.
:: He has claimed $65,400 in straight-line Depreciation on the Duplex.
:: He has claimed $7,644 in straight-line Depreciation on the garages.
:: His total straight-line Depreciation claimed is $73,044.
:: He has claimed $15,200 in accelerated Depreciation on the furniture.
:: His total overall Depreciation claimed is $88,244.
:: His current Depreciated Basis in the property is $161,756 (200,000 plus 30,000 plus 20,000 minus 88,244).
:: Bob Baker has offered him $400,000 cash for the Duplex.
:: If he accepts, his Capital Gains will be $238,244 (400,000 Sales Price minus 161,756 Depreciated Basis).
:: $15,200 of the $238,244 will be Recapture of Accelerated Depreciation, taxed at 37%, resulting in $6,019 in taxes.
:: $73,044 of the $238,244 will be Recapture of Straight-line Depreciation, taxed at 25%, resulting in $18,261 in taxes.
:: $150,000 of the $238,244 will be regular Capital Gains (400,000 minus 200,000 minus 30,000 minus 20,000) and will be taxed at 20%, resulting in $30,000 in taxes.
:: The total tax liability of Alan Adams on his $238,244 of Capital Gains will be $54,280 (6,019 plus 18,261 plus 30,000).
It's Like A Seminar In A Book
IF YOU USE A DELAWARE STATUTORY TRUST, TRIPLE NET LEASE, OR A T-I-C, YOU MUST HAVE THIS EDITION.
CAPITAL GAINS TAX
Your rental property is classified as Section 1250 Property, and any capital gains that you make on the sale of your 1250 Property is called Section 1250 Gain, and that profit is subject to capital gains tax.
In our scenario, if Alan Adams sells his property, he will have the following questions:
1. Is this a taxable transaction?
2. If so, what type of tax are we talking about?
3. How much is the tax?
4. What other factors besides the tax must be considered?
5. What are the bottom line numbers for this transaction?
SECTION 1250 GAIN
The IRS considers everything that you own to be a capital asset, and if you sell a capital asset, especially Section 1250 Property, for a profit, you have a capital gain.
A capital gain is income, but it is one of the different types of income, and is taxed at a rate called a Capital Gains Tax Rate. The Capital Gains Tax Rate is different for each taxpayer, but varies from 0% to 20%, depending on your income bracket.
Adams bought his Duplex for $200,000 and he is selling it for $400,000 so this is a taxable transaction.
And the tax we are talking about is Capital Gains Tax.
There are two types of capital gains tax, short term capital gains and long term capital gains.
Short term capital gains occurs when the taxpayer has held the capital asset for one year or less.
Long term capital gains occurs when the taxpayer has held the capital asset for at least a year and a day.
Adams has held his capital asset, the Duplex, for ten years so we are talking about long term capital gains.
A Section 1031 Exchange cannot be used to defer taxes on ordinary income, which is the tax rate for short term capital gains.
So you can only do a Section 1031 Exchange on long term capital gains, which means that you must have owned the property for at least a year and a day.
So, there is a minimum holding period, even though you will read a lot of other content on real estate investing saying that there is no minimum holding period. This is just another example of misinformation on the web.
To explain what I mean, go to the Form 8824 and look at the form on which you will report you Section 1031 Exchange, and you will see the rules.
The tax liability of Adams will depend on his tax bracket. He happens to be a highly-compensated individual in the highest marginal tax bracket of 37%, so he will pay 20% tax on his capital gains.
Remember, we are only dealing with Federal taxation here because all states with state income tax have their own tax code.
Some municipalities also have income taxing power, so there will probably also be state taxes, and possibly municipal taxes, due where the taxpayer lives.
Combined, these other taxes could total as much as 10%.
We are also not dealing with the additional 3.8% Medicare Tax that is being called an Investment Tax.
The total could be another 10-15% in addition to the federal tax, which is even more reason for you to do a Section 1031 Exchange.
For Adams, his pure capital gains that will be taxed at 20% will be computed as the difference between what he invested in the property and what he sells it for.
He bought the property for $200,000 and if he sells it for $400,000 he will have $200,000 of pure capital gains. We will ignore for the moment the $30,000 that he spent building two garages and the $20,000 that he spent on new furniture. We will add those later to illustrate a point.
So, if he sells for $400,000 he will have $200,000 of pure capital gains.
But he has also claimed depreciation. We will cover depreciation below.
I hope you are enjoying this free content.
The remainder of this content, plus additional content, is available in my book “How To Do A Section 1031 Like Kind Exchange: Simultaneous, Delayed, Reverse, Construction” available at Amazon.com/dp/B01MY433L6.
And if you are dealing with a Triple Net Lease, Delaware Statutory Trust, or a Tenancy-In-Common property, you need the OMNIBUS EDITION at Amazon.com/dp/B07BJLZNZN.
Or you can see all ten of my books on Real Estate Investing at Amazon.com/author/michaellantrip.
And I am re-writing all of this content for use on my Blog at MichaelLantrip.com, where it has already started appearing.