Why a 1031 Exchange May Be Smart Financial Planning
Should I pay the taxes, or defer? When selling real estate investment property, investors generally have two options: 1) pay the taxes on any gains from the sale, or, 2) conduct a 1031 exchange and defer the taxes owed. When it comes to smart financial planning, you want to make sure you're on the right page
Recently, because of the financial uncertainty surrounding COVID-19 and the overall state of the economy, some investors are choosing to pay the taxes on any gain from the sale of their investment properties and hold on to their cash rather than acquire replacement real estate utilizing the 1031 process.
While every investor is different and should make their own determination of their specific financial landscape and rely on the advice of their professional financial and legal counsel, there are generally two major points to keep in mind before choosing to pay the taxes rather than defer.
Point #1: the amount of taxes you might have to pay
If you choose to pay the taxes on your gain, you might be responsible for the following:
- Long term federal capital gains tax rate may be as high as 20%, depending on your income bracket.
- State tax can also add to the financial tax hit, depending on the State in which you live. For example, in California, an investor could possibly also pay up to 13.3% in income tax.
- Depreciation recapture is taxed at a flat rate of 25%, which can be quite significant if you’ve held and depreciated your investment property for a long period of time.
- Net Investment Income Tax (NIIT) applies to certain net investment income of investors that have income above the statutory threshold, at a rate of 3.8%.
Point #2: opportunity cost of any amount you pay in taxes
When an investor pays taxes, that could otherwise be deferred, they’re left with less capital that could otherwise be used for investment purposes that could generate more return for them.
Let’s use a simple example: Suppose that an accredited investor sells an investment property for $1 million, and the total amount of taxes that they would owe on such sale is $200,000. That accredited investor then decides, for purposes of our example, that they will pay the taxes owed and take the $800,000 in cash remaining and invest it in some investment that pays 5% annual interest. That investor, based on our example, should make a return of $40,000 per year.
However, if that same accredited investor had completed a 1031 exchange, for example into a DST, or Delaware Statutory Trust, paying 5% annually, their annual return should be $50,000, a difference of $10,000. While the above is a simplified example, it helps illustrate the opportunity cost of paying the taxes rather completing a 1031 exchange.
Before an investor decides to pay any owed taxes on the sale of their investment property rather than completing a 1031 exchange and deferring those taxes, they should thoroughly understand the financial implications by consulting with their professional tax advisor.
General Disclosure
Not an offer to buy, nor a solicitation to sell securities. Information herein is provided for information purposes only, and should not be relied upon to make an investment decision. All investing involves risk of loss of some or all principal invested. Past performance is not indicative of future results. Speak to your finance and/or tax professional prior to investing. The scenario provided above is a hypothetical illustration of mathematical policies only and is not a promise of investment performance.
Securities offered through Emerson Equity LLC Member: FINRA/SIPC. Only available in states where Emerson Equity LLC is registered. Emerson Equity LLC is not affiliated with any other entities identified in this communication.
1031 Risk Disclosure:
• There is no guarantee that any strategy will be successful or achieve investment objectives;
• Potential for property value loss – All real estate investments have the potential to lose value during the life of the investments;
• Change of tax status – The income stream and depreciation schedule for any investment property may affect the property owner’s income bracket and/or tax status. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities;
• Potential for foreclosure – All financed real estate investments have potential for foreclosure;
• Illiquidity – Because 1031 exchanges are commonly offered through private placement offerings and are illiquid securities. There is no secondary market for these investments.
• Reduction or Elimination of Monthly Cash Flow Distributions – Like any investment in real estate, if a property unexpectedly loses tenants or sustains substantial damage, there is potential for suspension of cash flow distributions;
• Impact of fees/expenses – Costs associated with the transaction may impact investors’ returns and may outweigh the tax benefits