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Deferring Capital Gains Taxes When Selling Property PART 1 of 5

Real Estate Agent with Retire On Income

Deferring Capital Gains Taxes When Selling Property

Part one of a 5 part Series on Deferring Capital Gains

Capital Gains Deferral

Deferral of capital gains has received much attention over the last few years as property values
have grown rapidly. Many tax experts will often advise their clients to just pay the taxes because
the capital gains rates are the lowest they’ve been in years and are likely to go up in 2011.
Advice such as this can be misplaced and may not be in the best interest of the property owner.
Take a hypothetical case in which someone purchased a property 20 years ago for $250,000.
Assume that the property has appreciated to $2,000,000. This appreciation represents a capital
gain of $1,750,000. If the property is located in California, then that property is subject to federal
capital gains taxes of 15% and state capital gains taxes of 9.3% for a total tax of 24.3%. This
total tax of 24.3% is $425,250 leaving the client a net of $1,324,750. Additionally, if the property
owner took depreciation over the 20 years, then that depreciation will be subject to as much as
34% recapture tax. For this example, we have assumed no depreciation.

So, when tax and investment professionals advise clients to pay taxes now, they fail to realize
that the taxes paid may very well represent a very large and significant portion of that client’s net
worth. Many times the cash proceeds from a property sale represent a client’s net savings for
retirement and cutting that number by 20%+ can make a very significant difference in the quality
of the property owner’s retirement.

What are Capital Gains?

Capital gains taxes are federal and state taxes applied to any gain or appreciation, on an asset,
above that asset’s basis or purchase price. Current federal capital gains rates are at 15% and state
rates vary from 4% to 9% bringing total taxes, in general, to roughly 20%-25%. Capital gains
taxes are applied at the time the sale takes place which is when the gain is realized. The taxes
must be paid in the year of sale.

The federal tax rate on long-term gains was reduced in 2003 to 15%, or to 5% for individuals in
the lowest two income tax brackets. In 2011 these reduced federal tax rates will "sunset," or
revert to the rates in effect before 2003, which were generally 20%.

Why Deferral of Capital Gains Taxes is Important

Most property owners understand the concept of time value of money and the importance of
getting and keeping as much cash as possible in today’s dollars so that you can invest those
monies and allow for compounding or returns on that money over time.

This same basic concept of compounding can be applied to paying capital gains taxes and taxes
on depreciation recapture. The key is to defer the payment of capital gains taxes and depreciation
recapture for as long as possible in order to yield the maximum return on those tax dollars.
In our example above, if the property owner were able to take the $425,250 in taxes and defer
that over 25 years, then the property owner would have actually ended up with more money than
when they started. If we assume that this money could grow at 6% rate of return per year for a
period of 25 years, then that $425,250 would have grown to over $1.8M.

1031 Exchange

This involves the exchange of a current property with a new property. This is most typically
accomplished through the use of an independent party known as a qualified intermediary (QI).
The QI takes possession of your property, sells it to a buyer, and then the QI holds onto the cash
proceeds until you find a replacement property. Upon finding a replacement property, the QI is
instructed to bring the cash to closing. Upon closing, the QI turns over the replacement property
to you. This entire process has to take place within 180 days of selling the current property.

David Harris

Great Post.

One disturbing trend that people should also be aware of in 1031 exchanges is abuse and mismanagement of money by exchange companies. I encourage everyone to thoroughly vet any potential qualified intermediary.

Consider working with a 1031 exchange company that deposits your money only in money-market accounts that invest in government backed securities. With uncertain market conditions, it’s the only way to ensure your money will be there when you need it. I only know of one such company, RockSolid 1031. You can check out their website at www.RockSolid1031.com.

Nov 20, 2008 04:36 AM