18 minute read
Tax Time
Even in the most robust seller's market, there is one thing that gives an investment property owner pause: capital gains taxes. And as an Oregon investment property owner, your tax liability on the sale of investment property can be substantial – as much as 37.7% - driving many investors to explore tax-deferral strategies like a 1031 Exchange.
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A Closer Look at Tax Liability
As a licensed 1031 Exchange Advisor, one of the first things we do when working with a client is to help them understand their tax liability. Tax liability from the sale of investment real estate is not just about federal capital gains tax – it is the total aggregate amount of tax owed when an investment property is sold. Not only are you responsible for Federal Capital Gains Tax (15% - 20%), but you may also have to pay State Capital Gains Tax (0-13.3%), Depreciation Recapture Tax (25%), and Net Investment Income Tax (3.8%).
How to Calculate Tax Liability
Federal & state tax authorities calculate the amount you owe based on the taxable gain, not the gross proceeds from the sale of the property. To estimate the total tax liability after the sale of an asset, follow these five steps:
Step 1: Estimate the Net Sales Proceeds
Start by determining the fair market value of the investment property or the list price if you brought the property to market. There are several ways to calculate the sales price, but the most popular are the income method and the comparable sale method. Smaller properties and single-family rentals typically rely on the comparable sales method, while larger properties rely on net operating income to determine value. For example, let us assume a comparison of similar local properties indicates a property may sell for $3,500,000 with $250,000 in deductible selling costs such as brokerage costs, title, escrow, and excise tax (if applicable). In this scenario, the net sales proceeds would be $3,250,000. Importantly, the net sales proceeds do not consider any loan balances paid off at closing.
Step 2: Estimate the Tax Basis
Tax basis, also known as remaining basis, is the total capital that an owner has invested and capitalized in the investment property, including the purchase price, closing costs, and capitalized improvements minus the accumulated depreciation. For example, if you purchased the property for $850,000, invested $200,000 in capital improvements and have $750,000 in depreciation, your remaining basis is $300,000. There are some limitations to the items that you can include in the tax basis. Mortgage insurance premiums and routine maintenance costs are examples of items that are not included. A tax advisor can help to determine your property’s current remaining basis, which can be adjusted based on capital improvements and tax deductions. their tax basis anytime they invest money into the property with capitalized improvements—such as a new kitchen, roof, or even an addition, as well as financing expenses. Expenses paid to operate the property, like legal fees, management expenses, and small repairs are not capitalized and instead treated as operating expenses. Capitalized improvements increase your investment in the property and are deducted from the net sales proceeds at the time of the sale to arrive at the property’s gain. While some of these costs are intrinsic to real estate investment, like escrow fees, others are flexible. A new roof, an upgrade to the kitchen, or adding a pool are capital improvements that have a wide range of costs, giving the owner some flexibility in the amount they can increase the tax basis of the asset versus deduct in the current year as an operating expense.
•Decreasing the Tax Basis: Owners of investment real estate that include a building or structure must also decrease the property’s tax basis, ultimately increasing the figure used to calculate the second form of gain referred to as “depreciation recapture”. The most common way to decrease the tax basis is through an annual depreciation deduction. The deduction is subtracted from the tax basis on an annual basis to be treated as a tax expense offsetting income which is then recaptured at the time of sale. While it might seem unexpected to decrease your tax basis and eventually increase your tax costs, the depreciation deduction reduces an investor’s annual taxable income and thus income tax due during the years of ownership. Note that annual depreciation is not optional. Investors will be charged for depreciation recapture on the aggregate amount of available depreciation throughout the period of ownership regardless of whether they recorded depreciation expense. Easements, some insurance reimbursements, and other tax deductions, like personal property deductions, can also decrease your tax basis.
Step 3: Calculate Taxable Gain
The taxable gain is the realized return or profit from the sale of an asset, or, in other words, it is the net sales proceeds less the original tax basis, pre-depreciation. Tax authorities like the IRS and Franchise Tax Board use the taxable gain figure to determine the capital gains tax. To calculate the taxable gain, subtract the original tax basis from the net sale proceeds. Using the earlier example, if your original tax basis is $1,050,000 and the net proceeds from the sale of the property is $3,250,000, your taxable gain is $2,200,000. The second part of the tax liability is calculated based on the amount of depreciation available to take over the period of ownership – referred to as accumulated depreciation. Based on the above scenario, this amount is $750,000.
Step 4: Determine Your Filing Status
Your income, tax filing status, the (continued on page 8)
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state where you pay income taxes, and the location of your investment property will determine your capital gains tax rate. The IRS, most state governments, and some local governments collect a capital gains tax on the sale of an investment property, compounding the rate and increasing your tax bill. At the federal level, the capital gains tax rate is 0% for investors with an annual income (including the gain resulting from asset sales) less than $40,000 per year; 15% for investors with an annual income from $40,001 to $441,450; and 20% for investors with an annual income above $441,451. Most state tax authorities collect a capital gains tax as well. The state tax rate ranges from 0% to 13.3% with California at the top of the list at 13.3%.
Step 5: Calculate the Capital Gains Tax
Capital gains taxes are applied to the taxable gain based on the tax rate determined by your income and filing status, and the bill can be significant. There are four property tax categories: federal capital gains taxes, state and local capital gains tax, depreciation recapture, and net investment tax. The federal and state capital gains taxes are calculated at the investor's tax rate on the taxable gain. In our example above, a California property owner with a taxable gain of $2,200,000 would owe 20% in federal capital gains tax and 13.3% in state capital gains tax amounting to $732,600 in total capital gains taxes. Individuals with significant investment and rental income may also have an additional 3.8% net investment tax— included as part of the Affordable Care Act—added on top of the capital gains rate. This brings the total capital gains bill in California to 37.1% or $816,200 on the example above. This example is unique to properties and taxpayers located in California, which has the highest capital gains tax rate in the country. In addition to capital gains taxes, real estate investors will also pay depreciation recapture. Investors take a depreciation deduction on their annual taxes to offset rental income. The depreciation deduction not only decreases the investor's annual tax liability but also decreases the remaining tax basis for the property. Once you sell the asset for a profit, you must pay back those deductions. This is depreciation recapture. The rate of tax on depreciation recapture is a flat rate of 25% at the federal level, can also include up to 13.3% state income tax, and be subject to net investment income tax for an additional 3.8%. While capital gains tax is based on the taxable gain, depreciation recapture is calculated based on the accumulated depreciation during the investor’s ownership. Based on $750,000 of accumulated depreciation, the depreciation recapture tax in this scenario could be as high as $315,750.
Deferring Capital Gains Tax with a 1031 Exchange By performing a 1031 Exchange, investment property owners can defer, reduce and even eliminate paying capital gains, depreciation recapture, and net investment income taxes on the sale of investment property. And while 1031 Exchanges are flexible in the number of strategies that can be implemented, the IRS’s rules to qualify are not flexible. Failure to adhere to IRS rules can result in either a failed Exchange, in which the entire tax liability is due, or a Partial Exchange, in which a portion of the tax liability is due (generally the most expensive portion). To learn more about 1031 Exchanges, visit our website at www. re-transition.com/rhaor and download our FREE guide, “Understanding 1031 Exchanges”. Improving Potential for Cash Flow with a 1031 Exchange In addition to tax savings, a 1031 Exchange can improve the potential for cash-flow and appreciation by allowing the proceeds to be reinvested. In our example, the investor’s total tax liability would be $1,131,950. If the post-tax proceeds of $2,118,050 were reinvested and earning a 5% return, this would generate $105,903 in annual income. However, by performing a 1031 Exchange, the investor would have $3,250,000 to reinvest. At the same return of 5%, the exchange proceeds would generate an annual cash flow of $162,500. Although potential cash flow/returns/appreciation is never guaranteed and could be lower than anticipated, the difference in cash flow potential of $56,500 represents one of the primary benefits of 1031 Exchanges – the ability to keep all your equity working for you to generate income and appreciation.
Learn More About 1031 Exchanges & Delaware Statutory Trusts If you have plans to sell your highly appreciated investment property and would like to learn more about taxdeferred 1031 Exchanges and Delaware Statutory Trusts, contact Real Estate Transition Solutions and speak to a licensed 1031 Exchange Advisor. We offer complimentary consultations that can be done over the phone, via web conference, or in person at one of our offices. To schedule your free consultation, call 503-946-5656, email info@retransition.com, or visit www.re-transition.com/rhaor.
Austin Bowlin, CPA is a Partner at Real Estate Transition Solutions and leads the firm's team of licensed 1031 Exchange Advisors & Analysts. Austin advises on tax liability, deferral strategies, legal entity structuring, co-ownership arrangements, 1031 Exchange options, and Delaware Statutory Trusts. About Real Estate Transition Solutions: Real Estate Transition Solutions is an advisory firm specializing in tax-deferred 1031 Exchange strategies, Delaware Statutory Trust investments, and fractional replacement property options. For over 20 years, we have helped investment property owners perform successful 1031 Exchanges by developing and implementing well planned, tax-efficient transition strategies carefully designed to meet their financial & lifestyle objectives. Our team of licensed 1031 Exchange Advisors will guide you through the entire Exchange process and help you select and acquire 1031 replacement properties best suited to meet your goals. To learn more about Real Estate Transition Solutions, visit our website at www.re-transition.com. This is for informational purposes only, does not constitute as individual investment advice, and should not be relied upon as tax or legal advice. Please consult the appropriate professional regarding your individual circumstance. Because investor situations and objectives vary this information is not intended to indicate suitability for any individual investor. There are material risks associated with investing in DST properties and real estate securities including liquidity, tenant vacancies, general market conditions and competition, lack of operating history, interest rate risks, the risk of new supply coming to market and softening rental rates, general risks of owning/ operating commercial and multifamily properties, short term leases associated with multi-family properties, financing risks, potentially adverse tax consequences, general economic risks, development risks, long hold periods, and potential loss of the entire investment principal.Potential cash flows/returns/appreciation are not guaranteed and could be lower than anticipated. Diversification does not guarantee a profit or protect against a loss in a declining market. It is a method used to help manage investment risk. DST 1031 properties are only available to accredited investors (typically defined as having a $1 million net worth excluding primary residence or $200,000 income individually/$300,000 jointly of the last three years; or have an ac tive Series 7, Series 82, or Series 65. Individuals holding a Series 66 do not fall under this definition) and accredited entities only. If you are unsure if you are an accredited investor and/or an accredited entity, please verify with your CPA and Attorney. This article was collectively authored by Austin Bowlin and a paid third-party firm. Real Estate Transition Solutions offers securities through Concorde Investment Services, LLC (CIS), member FINRA/ SIPC. Advisory services through Concorde Asset Management, LLC (CAM), an SEC-registered investment adviser. Real Estate Transition Solutions is independent of CIS and CAM. Real Estate Transition Solutions offers securities through Concorde Investment Services, LLC (CIS), member FINRA/SIPC. Advisory services through Concorde Asset Management, LLC (CAM), an SEC-registered investment adviser. Real Estate Transition Solutions is independent of CIS and CAM. Sources: https://www.irs.gov/taxtopics/tc409, and https://taxfoundation.org/stateindividual-income-tax-rates-and-brackets-for-2020
Why is DST Real Estate a Popular 1031 Exchange Option?
Just Ask a Few Oregon Landlords.
A 1031 Exchange into DST real estate helped these landlords meet their objectives. By selling their rental property and investing in three DSTs, they avoided paying 37.7% in gains tax while increasing income potential, diversifying risk, and eliminating active property management.
Before 1031: Landlords After 1031: DST Property Investors
Sold Rental Property. Performed a 1031 Exchange. Deferred $423K in gains tax. Invested in 3 passive management 1031 DST properties with monthly income potential.
Whole Ownership Rental Property Fractional Ownership in Institutional DST Properties
Example and pictures are for illustrative purposes only and are intended to show types of institutional properties that DST Sponsors seek to own. It does not constitute open or closed offerings. Individual results may vary.
1031 EXCHANGE
Download your FREE Guide: re-transition.com/rhaor
INVESTING IN DELAWARE
STATUTORY TRUSTS
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Learn more about 1031 Exchange DST property investments and fractional real estate ownership. Speak to a licensed 1031 Advisor at Real Estate Transition Solutions by calling 503-946-5656.
This is for informational purposes only, does not constitute as investment advice, and is not legal or tax advice. Please consult the appropriate professional regarding your individual circumstance. There are material risks associated with investing in DST properties and real estate securities including liquidity, tenant vacancies, general market conditions and competition, lack of operating history, interest rate risks, the risk of new supply coming to market and softening rental rates, general risks of owning/operating commercial and multifamily properties, short term leases associated with multi-family properties, financing risks, potential adverse tax consequences, general economic risks, development risks, long hold periods, and potential loss of the entire investment principal. Potential cash flows/returns/appreciation are not guaranteed and could be lower than anticipated. Diversification does not guarantee a profit or protect against a loss in a declining market. It is a method used to help manage investment risk. DST 1031 properties are only available to accredited investors (typically have a $1 million net worth excluding primary residence or $200,000 income individually/$300,000 jointly of the last three years) and accredited entities only. If you are unsure if you are an accredited investor and/or an accredited entity, please verify with your CPA and Attorney. Real Estate Transition Solutions offers securities through Concorde Investment Services, LLC (CIS), member FINRA/SIPC. Advisory services through Concorde Asset Management, LLC (CAM), an SEC-registered investment adviser. Real Estate Transition Solutions is independent of CIS and CAM. The company depicted in the photographs herein may have proprietary interests in their name and trademark. Nothing herein shall be considered an endorsement, authorization or approval of RETS, CIS, and CAM or the investment vehicles they may offer, of the aforementioned company. Further, none of the aforementioned company is affiliated with RETS, CIS, and CAM in any manner.
Recently, and strictly out of curiosity, I went online to a web site called www.supportpets.com to see how difficult or easy it was to obtain a document to qualify my cat, Oliver, as an emotional support animal (ESA). Once I entered in my personal information, including my email address, I was presented with a series of about 15 questions to which I had to choose answer of “yes, no, always, sometimes or never”. and licensing documents for assistance animals to anyone who answers certain questions or participates in a short interview and pays a fee.
Under the Fair Housing Act, a housing provider may request reliable documentation when an individual requesting a reasonable accommodation has a disability and disability-related need for an accommodation that is not obvious or otherwise known.
In HUD’s experience, such documentation from the internet is not, by itself, sufficient to reliably establish that an individual has a non-observable disability or disability-related need for an assistance animal.
By contrast, many legitimate, licensed health care professionals deliver services remotely, including over the internet. One reliable form of documentation is a note from a person’s health care professional (on their letterhead) that confirms a person’s disability and/or need for an animal when the provider has personal knowledge of the individual.
Information Confirming Disability-Related Need for an Assistance Animal
Reasonably supporting information often consists of information from a licensed health care professional- e.g., a physician, optometrist, psychiatrist, psychologist, physician’s assistant, nurse practitioner, or nurse-general to the condition but specific as to the individual with a disability and the assistance or therapeutic emotional support provided by the animal.
A relationship or connection between the disability and the need for the assistance animal must be provided. This is particularly the case where the disability is non-observable, and/or the animal provides therapeutic emotional support.
For non-observable disabilities and animals that provide therapeutic emotional support.
For non-observable disabilities and animals that proved therapeutic emotional support, a housing provider may ask for information that is consistent with that indentified in the Guidance on Documenting an Individual’s Need for Assistance Animals in Housing (*see Questions 6 and 7) in order to conduct an individualized assessment of whether it must provide the accommodation under the Fair Housing Act. The lack of such documentation in many cases may be reasonable grounds for denying a requested accommodation.
The questions were along the lines of the below: Do you feel anxiety when you are not with your pet? •Have you experienced an event that has caused you to be more anxious than usual? (COVID) •Does your pet give you comfort and relieve some of your anxiety? •Do you experience depression when away from your pet? •Do you notice that when you are with your pet that you are in a better mood? •Etc., etc.
I answered most of the questions with either “yes” or “sometimes” and once completed, (ti took about five minutes), received immediate results that said, “Congratulations! Oliver qualifies as an emotional support animal.” Then, I was instructed to pay $194 to have the document sent to me. Naturally, I didn’t pay, but instead, I picked up the phone and dialed the number they gave me for any questions. I asked them if it was a medical professional that would be signing the documents and they assured me that yes, it was indeed a medical professional.
I informed them that landlords requested that the tenant have a personal relationship with the doctor and if the medical professional who was signing the documents would be from my area. With that question, I was put on hold for about three minutes. The woman came back on the line and said that yes, they could accommodate that. Now, whether they actually could or not was not determined as I was not about to give these thieves my $194.00.
Since then, I have received numerous emails asking me to complete my order for my ESA documents with an offer of 50% off. Their long emails have stories and testimonies from others who have applied and gotten their documents. One person claimed, “My ESA letters came within 6 hours of ordering! Such quick delivery allowed me to sign a new lease in the high rise apartment of my dreams that day.”
Their emails also stated that my ESA order would include: •ESA approval from a licensed doctor delivered within 48 hours. •ESA Approval on 2nd pet free of charge. •ESA Approval that includes doctor’s license & signatures. •Full Federal protection under both FHA and ACAA Laws. •Access to custom ESA forms if needed for landlords and airlines. To read HUD’s entire guidance notice, visit https://www.hud. gov/sites/dfiles/PA/douments/HUDAsstAnimalNCI-28-2020. pdf
Now…advertisements for this company are showing up on my Facebook thread and in advertisements everywhere I go on the internet. Unbelievable.
Reminder of the Law
Earlier last year, the U.S. Department of Housing and Urban Development (HUD) released new guidance clarifying the responsibilities of both rental housing providers and renters when it comes to reasonable accommodation requests for emotional support animals (ESA’s) in housing.
Documentation from the Internet
It was stated that some websites sell certificates, registrations, Don’t get me wrong. I am an avid animal lover. I do believe that certain cases of people needing an emotional support animal are legitimate, but what I don’t support is dishonesty, falsified information or any form of scam whatsoever. And it seems to me, that websites that offer these docs, the medical professionals who work with them and the people who utilize them are guilty of all of the above.
Disclosure: Permission was granted from Oliver for the one-time sue of his photo for this article. Patricia Harris is Senior Editor of the AOA Buyers Guide and Magazine. RHA Oregon Editor’s note: There is a company called petscreening.com that will verify the need for the assistant animal for cost for landlords and property owners.
