Buying and selling investment real estate can be incredibly rewarding and profitable for real estate investors and agent. However, to be truly successful in building a real estate portfolio, investors and agents must learn how to manage — or more importantly defer — the capital gain, depreciation recapture and Medicare Surcharge (Obamacare tax) income tax liabilities triggered by the sale of investment real property.
Federal and state depreciation recapture and/or capital gain income taxes can be as high as 35%, and even higher under certain circumstances. Payment of these taxes can dramatically diminish an investor's equity and cash positions, which in turn impedes the investor's ability to grow his net worth by acquiring larger properties that produce greater cash flow.
Real estate agents and other professional advisors can significantly increase their value to their clients by assisting them in deferring 100% of their income tax liabilities by structuring their real estate transactions as 1031 tax-deferred exchanges. Investors will be able to exchange into larger properties with greater income potential because 100% of their equity remains invested and working for them instead of going toward the payment of income taxes.
Agents and investors often ask when they should complete a 1031 exchange, and what’s the best way to take advantage of the 1031 exchange. The short answer is: always exchange; always defer the income taxes! In other words, the best way to use the 1031 exchange is to always keep the equity invested by structuring 1031 exchanges. Always complete 1031 exchanges throughout your lifetime and never stop exchanging. Never pay income taxes on the sale of investment property unless there is a very good reason for doing so.
By following this income tax strategy the investor will continue to exchange throughout his or her lifetime and will always defer the income tax liabilities each time he or she sells investment real estate by acquiring replacement property. The value of his or her real estate portfolio will grow exponentially faster when the income taxes are deferred, and consequently his or her net worth will also grow substantially greater than if he or she paid income taxes throughout their life.
When the investor passes away his or her heirs will receive a step-up in cost basis equal to the fair market value of the property as of the date of his or her death, or the heirs can elect an alternate valuation date six months after the date of his or her death. The heirs could immediately sell the property without incurring any depreciation recapture and/or capital gain income tax liabilities.
A father bought real property for $150,000 (his original cost basis). When the father died the real estate had a fair market value of $650,000 on the date of his death. The real property was inherited by his son. The son will receive a step-up in cost basis on the property equal to the fair market value on the date his father died, so the son's cost basis would become $650,000 (the son's new cost basis). The $500,000 in capital gain while the real estate was held by the father is not subject to capital gain income taxes. If the son were to immediately sell the real property for $650,000 there would be no capital gain income taxes owed by the son. If the son were to sell the real estate later for $1,000,000 the son would only owe capital gain income taxes on the $350,000 gain.
However, the fair market value of the real property is included in the father’s estate and it may be subject to federal, and possibly state, estate (inheritance) taxes. Investors should always consult with an estate planning specialist for assistance in planning for and minimizing his estate taxes.