from IPX1031 July Newsletter (www.ipx1031.com)
This statement results from having “phantom income”; that is, taxable gain but no cash to pay taxes with. Sometimes in a flat or down market, investors do not properly consider the tax consequences of a sale. As a consequence, they experience a terrible surprise when their CPA gives them their tax returns to sign and file.
Capital gain is the difference between the net sales price of a property and its tax basis NOT the difference between the net sales price and its purchase price. The tax basis of a property starts as the purchase price of the property adjusted by the costs of purchase (non-recurring costs of purchase paid by the purchaser, such as recording fees, commissions, etc.). However this figure changes over the time the property is owned. It is increased by capital improvements to the property; things that add value to the property and cannot be expensed such as the cost of a garage added to a rental home. The tax basis is reduced by accumulated depreciation taken on the property. Remember that depreciation is mandatory and the failure to take it on an investment property can lead to another unpleasant surprise; that is, paying depreciation recapture tax on what could have been deducted!
Let’s assume that you purchased a property five years ago for $260,000, put $5,000 of capital improvements into it and took about $36,000 in depreciation deductions. Your tax basis is $229,000 ($260,000 + $5,000 – $36,000). If you sell it for $250,000 ($10,000 less than you paid) you will have a capital gain of $31,000 (the sales price of $250,000 minus the tax basis of $229,000). Accordingly, it is very important to know what your tax basis is in a piece of investment property to avoid the “April Surprise”.
It is even more important if you did a 1031 exchange into the property being sold. In a 1031 exchange the capital gain tax is deferred which allows an investor to reinvest ALL of the equity (to generate income for the investor) rather than just the after-tax equity. However, putting it very simply, the tax basis from the old investment property (relinquished property) is transferred to the new investment property (replacement property).
To illustrate how investors fall victim to the April Surprise, let’s take the following example. Last year you sold a rental home you owned for many years for $200,000. You did a 1031 exchange and your CPA properly transferred its $100,000 tax basis to your new investment property. After a year you have been unsuccessful in finding a suitable tenant and you sell the property for $190,000. Conventional wisdom would say you do not owe any tax because you sold it for a $10,000 loss, right? WRONG. You have a capital gain of $90,000! Your sales price was $190,000 but your tax basis is $100,000. Between federal and state taxes you will probably owe between 25 to 30% of the gain in taxes ($22,500 to $30,000).
Is this result inevitable? No. You should do a 1031 exchange. By doing an exchange you can avoid paying taxes on a gain with money you do not have. In summary, it is extremely important that you have an open dialogue with your CPA to avoid the “April Surprise”.
When you choose IPX1031® as your Qualified Intermediary, you can be confident that your exchange will be handled expertly and that your funds will be safe, secure, and available when needed. Please call us when we can be of service, or if you have any questions.