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.
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%.
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
Perch Financial LLC and Emerson Equity LLC do not provide legal or tax advice. Securities offered through Emerson Equity LLC Member FINRA/SIPC and MSRB registered. Emerson Equity LLC is unaffiliated with any entity herein. 1031 Risk Disclosure:
No offer to buy or sell securities is being made. Such offers may only be made to qualified accredited investors via private placement memorandum. Risks detailed in a private placement memorandum should be carefully reviewed, understood, and considered before making such an investment. Prospective strategies and products used in any tax advantaged investment planning should be reviewed independently with your tax and legal advisors. Changes to the tax code and other regulatory revisions could have a negative impact upon strategies developed and recommendations made. Past performance and/or forward-looking statements are never an assurance of future results.
Many of the investments offered will be only available to those investors meeting the definition of an Accredited Investor under SEC Rule 501(A) and offered as Regulation D private placement securities via a Private Placement Memorandum (“PPM”). Prospective investors must receive, read, and understand all the risks associated with buying private placement securities. Investments are not guaranteed or FDIC insured and risks may include but are not limited to illiquidity, no guarantee of income or guarantee that all tax advantages or objectives will be met and complete loss of principal investment could occur.
Risk Disclosure: Alternative investment products, including real estate investments, notes & debentures, hedge funds and private equity, involve a high degree of risk, often engage in leveraging and other speculative investment practices that may increase the risk of investment loss, can be highly illiquid, are not required to provide periodic pricing or valuation information to investors, may involve complex tax structures and delays in distributing important tax information, are not subject to the same regulatory requirements as mutual funds, often charge high fees which may offset any trading profits, and in many cases the underlying investments are not transparent and are known only to the investment manager. Alternative investment performance can be volatile. An investor could lose all or a substantial amount of his or her investment. Often, alternative investment fund and account managers have total trading authority over their funds or accounts; the use of a single advisor applying generally similar trading programs could mean lack of diversification and, consequently, higher risk. There is often no secondary market for an investor's interest in alternative investments, and none is expected to develop. There may be restrictions on transferring interests in any alternative investment. Alternative investment products often execute a substantial portion of their trades on non-U.S. exchanges. Investing in foreign markets may entail risks that differ from those associated with investments in U.S. markets. Additionally, alternative investments often entail commodity trading, which involves substantial risk of loss.
NO OFFER OR SOLICITATION: The contents of this website: (i) do not constitute an offer of securities or a solicitation of an offer to buy of securities, and (ii) may not be relied upon in making an investment decision related to any investment offering by Perch Financial LLC, Emerson Equity LLC, or any affiliate, or partner thereof. Perch Financial LLC does not warrant the accuracy or completeness of the information contained herein.
