How Much Can I Save in Capital Gains Taxes With a 1031 Exchange?

Investing in real estate can be lucrative, but it's not without its challenges, especially when it comes to taxes. However, savvy investors have a powerful tool at their disposal: the 1031 exchange. Named after Section 1031 of the Internal Revenue Code, this tax-deferral strategy allows property owners to defer capital gains taxes when they sell a property, provided they reinvest the proceeds into a "like-kind" property. But just how much money can you save with a 1031 exchange? In this article, we'll delve into the financial benefits (and potential pitfalls) of utilizing a 1031 exchange, breaking down exactly how much you can save in capital gains taxes with this process.

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How Does It Work?

In our recent article, “How Reverse 1031 Exchanges Work,” we broke down the process of a standard 1031 exchange.

1. Sell your commercial property.
2. Instead of paying taxes on the gains from the sale, defer such gains through a 1031 exchange.
3. A qualified intermediary holds your profit in an escrow account as you identify one or more replacement properties. 
4. Close on the replacement property within six months of the original sale and use the gains from the sale on a tax-deferred basis. 

This seems straightforward enough, but the amount of money saved is highly variable and takes into account your annual federal and state income, the state in which the transaction takes place and how long you’ve owned the property.

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Do I Pay Federal Capital Gains Taxes?

Just like income, capital gains are taxed at the federal and state levels — an important consideration when calculating your total profit and savings. At the federal level, capital gains are taxed at various rates depending on household income levels but for most real estate investors, it amounts to a 20% federal tax plus any applicable state taxes. 

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Why Are Capital Gains Taxes Different in Different States?

When calculating how much money you will save with a 1031 exchange (and deciding if a 1031 exchange is worth your while), you first need to know the capital gains laws of the state in which the transaction will take place. For example, a handful of states like Texas and Wyoming don’t charge any capital gains taxes, making them a popular hub for sales of large assets. Because capital gains taxes are tied to income, it makes sense that most of those states don’t collect resident income tax.

For states that do collect capital gains taxes, the rates are highly variable. For example, California’s highest income rate is 13.3%, while North Carolina's is only 4.75%, a jaw-dropping difference for investors considering real estate investments in multiple states.

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What Is The Difference Between a Short-term and Long-term Gain or Loss?

Capital gains vary depending on how long you own your property before you sell it. If you own it for less than one year, it qualifies as short-term, meaning it will be taxed as regular income. Because these rates are variable, you could pay a maximum of 37% as a high earner in the highest tax bracket. 

If you own your property for a year or more, the capital gains tax rate caps out at 20%. So, if you’re an investor eyeing mostly short-term real estate investments, filing a 1031 exchange saves you even more in capital gains taxes.

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How Much Can I Save in Capital Gains Taxes with a 1031 Exchange?

Taking federal and state income tax rates into account, as well as the length of time you’ve owned the property, you (or a qualified intermediary who is required to handle the paperwork for the exchange) can calculate your total profit and capital gains taxes avoided. Take a look at the example below for a breakdown of potential savings for a 1031 exchange in the state of Michigan.

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Original property sale details:

• Sale price: $500,000
• Original purchase price: $300,000
• Depreciation claimed: $50,000
• Adjusted basis:some text
  • Original purchase price - Depreciation = $300,000 - $50,000 = $250,000
• Mortgage balance at sale: $200,000

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Capital gains calculation:

• Total gain:some text
  • Sale price - adjusted basis = $500,000 - $250,000 = $250,000
• Assume 20% for long-term capital gains + 3.8% net investment income tax + 4.25% State of Michigan income tax
• Capital gains tax liability (without 1031): $250,000 x 28.05% = $70,125

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Replacement property details:

• Purchase price: $600,000
• Mortgage amount: $300,000

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Mechanics:

• Taxpayer defers $70,125 in capital gains and state income tax.
• The entire $500k from the sale is applied to the purchase of the new property.
• The equity from the sale ($300k) is rolled into the new property.
• The new mortgage ($300k) is greater than the prior mortgage balance ($200k).
• Full deferral of taxes as the equity and debt requirements are satisfied.

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Breaking It Down

The amount of money you can save in capital gains taxes through a 1031 exchange hinges on your annual income, the state-specific tax implications, and the nature of your property ownership. With a careful strategy to apply your knowledge to your transaction, you can not only defer substantial tax payments, but also enhance your ability to reinvest and grow your real estate portfolio more effectively.

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Discover how much you can save with a 1031 exchange. National 1031 is your expert in guiding you through a 1031 exchange and serving as your Qualified Intermediary. Contact us today with your 1031 exchange questions using the form below.

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