With just about six weeks remaining in the income tax season, investment strategies and mitigation of tax obligations are popular topics among commercial property investors. New tax laws and tax increases have investors and high wage earners looking for relief, while tax accountants look forward to a banner year.
The New England Real Estate Journal published a helpful article that provides guidance for affected taxpayers. I’m sharing the highlights with you here, along with my own information.
There are two main tax issues for investment earners. First, the capital gains tax rate went from 15% to 20%, affecting single filers earning over $400,000 and married couples filing jointly earning over $450,000.
Next, the 3.8% “Medicare Tax”, passed with the Affordable Care Act, hits individuals earning over $200,000 and married couples filing jointly earning over $250,000. The tax applies to passive investment income, much like a capital gains tax, affecting earnings from dividends, interest earned, and so on.
Some relief can be found using provisions from section 1031 of the Internal Revenue Tax Code. Current IRS guidelines state the following: “To the extent that a gain from a like-kind exchange is not recognized for income tax purposes under Section 1031, it is not recognized for purposes of determining net investment income under Section 1411.”
This is a fancy way of saying that the good-old-fashioned 1031 exchange helps investors defer the new 3.8% Medicare Surtax. At least, until the IRS decides otherwise.
In fact, investment property owners who exchange like-kind properties under a 1031 exchange, instead of selling a property outright, can potentially defer all capital gains taxes that would otherwise be owed. Also, the definition of “like-kind” is fairly broad; it doesn’t mean that an 8-unit apartment building needs to be strictly exchanged for another 8-unit apartment building. You can exchange your apartments for an office building, or a strip mall, or any other viable investment property.
This is not a new strategy; the 1031 exchange has been around practically forever. It fell a bit out of practice when lower tax rates meant less emphasis on tax mitigation. If you would like to brush up on the 1031 exchange, there is a library of links and resources in the National Association of REALTORS® Field Guide to 1031 Exchanges. You can also get started by visiting the topic on IRS.gov.
A note of caution: if you perform a 1031 exchange but “trade down” – failing to fully reinvest the value of your property – you are subject to depreciation recapture, which has a tax rate of 25%. Bankrate has an article with some strategies to avoid this.
Please remember that IRS rules are subject to change, and nothing in this post is meant as legal advice. Consult your professional tax preparer or attorney for proper guidance!
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