Prices in many real estate markets have regained their pre-financial-crisis levels. Prices in some areas have surpassed those levels and are still going up. That means many real estate investors now own properties that are worth way more than their tax basis. That’s especially likely with a rental property for which you’ve claimed depreciation deductions over the years. Those depreciation write-offs reduced your tax basis in the property, resulting in a bigger taxable gain if you sell.
Here’s the message: If you are a well-seasoned individual who owns real property that would trigger a big taxable gain if sold, please think long and hard about not selling. Why? Because simple inaction or arranging for a tax-free Section 1031 exchange, instead of a sale, could be tax-smart strategies.
This column explains why, after first covering some necessary background information. Let’s get started.
Tax basics for greatly-appreciated real estate
If you sell a greatly-appreciated property, you will probably pay the maximum 20% federal long-term capital gains rate on your whopping big profit. If we are talking about a rental property, you will probably pay a 25% federal rate on the portion of the gain that’s attributable to depreciation write-offs. You’ll probably owe the dreaded 3.8% net investment income tax too. If you live in a state with a personal income tax, you can pile that tax rate on top of what you’ll owe the Feds. When you add up all the rates, the total could be an unacceptably high percentage of the sale price (see below). What to do? Please keep reading.
Tax-saving solution: hang onto your property until the bitter end
The simplest tax-saving strategy in the greatly-appreciated real property scenario is to do nothing. Hang onto the property. Don’t sell it. Here’s why. For federal income tax purposes, the tax basis of real property that you still own when you depart this cruel orb is stepped up (increased) to fair market value (FMV) as of: (1) the date of your death or (2) six months after that date, if the executor of your estate chooses the later date, according to Internal Revenue Code Section 1014(a).
* If you are unmarried, the basis step-up rule applies to your entire ownership interest in the property. So when your heirs sell the property, federal capital gains taxes will only be due on the additional appreciation (if any) that occurs after the magic date.
* If you are married and your spouse own the property together, the tax basis of the portion you own is stepped up when you die. The basis of the remaining portion is stepped up when your spouse dies. Once again, your heirs will probably owe little or nothing to Uncle Sam when the property is sold.
* If you and your spouse own real estate as community property in one of the nine community property states, the tax basis of the entire property is generally stepped up to FMV when the first spouse dies — not just the half that was owned by that person, according to Internal Revenue Code Section 1014(b)(6). This strange-but-true rule means the surviving spouse can then sell the property and owe little or nothing to the Feds.
* If the taxpayer-friendly basis step-up deal is also available under applicable state income tax rules, the hang-onto-the-property strategy works the same tax-saving magic for state income tax purposes.
Alternative tax-saving solution: arrange Section 1031 exchange and hang onto the replacement property
You may love the idea of avoiding taxes on your greatly-appreciated investment real estate, but you might want to unload your current property and reinvest in other property that you think has more potential for future appreciation. In that case, consider doing a tax-free Section 1031 exchange. You swap your current property for replacement property that you think has more upside. With proper planning and attention to detail, the Section 1031 exchange rules allow you to avoid most or all of the tax hit from unloading the current property. The untaxed gain from the current property reduces your tax basis in the replacement property. So you start off with a built-in tax gain on the replacement property. But if you hold that property until the bitter end, the aforementioned basis step-up rule can work its tax-saving magic for your heirs.
Adding up the tax hits on a big gain from selling investment real estate
If you have a large taxable gain on sale of investment estate, the taxes can add up like this:
* 25% federal rate on long-term gain attributable to depreciation deductions claimed for a rental property.
* 20% federal rate on remainder of long-term rental property gain or long-term land-sale gain.
* 3.8% federal net investment income tax rate.
* State income tax rate, if applicable. If you live in California or New York City, the state and local tax hit on a whopping real property gain could around 13%, which could result in a combined federal, state, and local tax rate in the 37% to 40% range. Yikes. While tax rates in other jurisdictions are lower, they can still be painful.
The bottom line
Doing nothing is not usually a good tax planning strategy, but the greatly-appreciated real property scenario is an exception — if you hang onto the property until death. The other tax-saving strategy is to arrange a tax-free Section 1031 exchange, and then hang onto the replacement property until you depart. If you are interested in the Section 1031 exchange idea, consult a pro who handles these deals on a regular basis. Section 1031 exchanges are not good DIY projects, but the tax savings can be huge.