Should You Take Advantage of the New Capital Gain Rates, or Do a 1031 Exchange?

Now that tax rates on capital gains have dropped to 15% (from 20%), a lot of our clients are wondering whether they should just pay the tax or do a tax-deferred exchange when they sell their property. If you do not want to buy another property, or if you are selling bare land, then perhaps paying the tax may be the route for you. On the other hand, if you are going to buy another property, or if you’ve depreciated your old property, it probably makes more sense to do an exchange.

While the new 15% capital gain rate seems tempting, what many people don’t realize is that congress did not change the tax rate on recapture of depreciation. That rate stays the same at 25%, and depreciation is recaptured first, meaning that you pay the recapture tax before paying the new 15% rate on the balance. For example, if you have taken $20,000 in depreciation, and you have a total gain of $50,000, the first $20,000 of gain is taxed at 25% (i.e., $5,000) while the remaining balance of $30,000 is taxed at 15% (i.e., $4,500) for a total of $9,500. This represents an overall tax rate of 19% and is more than the $7,500 (i.e., 15% X $50,000) you probably thought you were going to pay.

The impact then gets worse because the $50,000 gain comes in beneath your other income and pushes you up into higher tax brackets. For example, if your taxable income without the gain is $100,000, your tax under the new law would be about $18,600 (using the tax tables and assuming married filing jointly). Now, with the $50,000 gain, your taxable income is $150,000, and you would pay tax of $32,200 minus the tax on the gain (as calculated above) of $9,500 for a net of $22,700, meaning you’ll pay $4,100 of additional tax ($22,700 - $18,600). In other words, you originally thought the tax was going to be $7,500 and it is actually going to be more like $13,500 ($9,500 + $4,100) – almost twice what you were expecting to pay. And at 27%, almost twice the rate you expected.

Another argument that I’ve heard for not doing an exchange is that with taxes so low, now is a good time to pay the deferred tax on the old property and get a larger depreciation deduction on the new property. Let’s think this through for a minute: you pay the tax up front in cash, and then you recover it through larger deductions in the future. In other words, using our example, you pay $13,500 now, and then you get it back over the next 27 or 39 years depending on the type of property you buy. And if you buy bare land as your replacement property, you can’t take depreciation so you have to wait until you sell it in order to recover the cash you’ve paid now. Present value calculations are beyond the scope of this article, but you get my drift.

In considering your real estate investment decisions, choose a qualified intermediary that is not only well-versed in the new tax changes, but one who carefully thinks through your individual situation.