Counseling Clients on the Layers of Section 1031 Taxationby
Accountants who have clients preparing to conduct a 1031 exchange can create value and increase retention probability in various ways, some of which have been discussed some of these ways in previous posts.
For instance, accountants can give rudimentary counsel regarding the risks associated with partnership transactions. You can also inform them about the multiple layers of taxation triggered by the sale of business or investment real estate.
If clients have a sense of these different layers, they can gain a fuller understanding of the benefits of Section 1031. And, in some cases, they can get a head start on preparing for whatever tax liability they may incur if they conduct a partially taxable transaction or fail to complete their exchange.
Real estate sales can trigger four distinct layers of taxation: federal, state, net investment income tax and depreciation recapture. Let’s examine each of these in detail.
The Federal and State Layers
When a taxpayer performs a 1031 exchange, they may defer the federally imposed capital gains taxes. When real estate is held for business or investment purposes, it is considered a capital asset to the holder. This means the capital gains tax rates will apply to any gains recognized by the taxpayer. There are two distinct types: the short term and long term. If the real estate is held for less than a year, then the short-term capital gain tax rate will apply. This corresponds to the given taxpayer’s ordinary income rate. If the asset is held for a period greater than one year, the long-term rate applies; it is presently 0, 15 or 20 percent. Which specific long-term tax rate applies depends on the income of the taxpayer.
Along with federal capital gain taxation, many states also impose a personal income tax on residents. If a taxpayer resides in such a state, they may incur a state tax liability if the 1031 exchange yields any taxable income. State tax rates vary widely. Taxpayers will need to check which applies in their individual case. Some states, such as Washington, actually have no personal income tax, so state taxation would not apply in such instances. But the vast majority of states in our union do collect personal income taxes. State income tax rates vary from a low of 2 percent up to 13.3. Some have a flat personal income tax, while others have a graduated system modeled after the federal income tax system. Again, depending on the situation, taxpayers will need to budget for this additional layer of taxation.
The NIIT and Depreciation Recapture
Taxpayers may also be subject to the “net investment income tax” (NIIT) and depreciation recapture. The NIIT, sometimes referred to as the Medicare Investment Income Surtax, consists of an additional 3.8 percent tax on certain income. The NIIT tax rate applies to those who have modified adjusted gross income (MAGI) above certain thresholds. The threshold for individuals is $200,000; for married couples filing jointly, it’s $250,000, and for those who are married and filing separately, it’s $125,000.
This means those with MAGI below these thresholds are not subject to the tax. But, for those who have MAGI above their applicable threshold, the tax is collected on the lesser of that taxpayer’s net investment income, or income above the threshold.
Let’s look at an example: Suppose a married couple filing jointly has a MAGI of $370,000 but a net investment income of $80,000. The couple would have income above the exemption of $120,000, so the 3.8 percent tax would apply to the net investment income of $80,000 rather than the income above the exemption.
Computing the NIIT is usually quite difficult and will require a considerable amount of time, making it the perfect opportunity for an enterprising accountant to distinguish themselves. You can also alert clients to the potential applicability of the NIIT in the case of any recognized gains deriving from the exchange.
The final layer of taxation is depreciation recapture. Fortunately, this is a bit less complex than the NIIT and consists of a 25 percent flat tax on depreciation taken during the course of ownership. As with the NIIT, depreciation recapture is separate from federal capital gains taxation.
Let’s look at another hypothetical for clarification. Suppose an investor buys a property for $1 million and then takes $100,000 in depreciation deductions over the course of ownership. When the investor eventually sells the property for $1.5 million, they will be taxed separately at the 25 percent rate for the depreciation which has been taken. This means they will owe 25 percent on the $100,000.
Depreciation recapture is meant to tax the “gain” associated with the deductions taken by the taxpayer. This means the tax will only be triggered if the taxpayer sells the property for more than cost basis adjusted for depreciation.
Clients need to be aware of the kind of tax liability they can incur if they have a taxable 1031 transaction. Many may take out taxable boot from the exchange or decide to abandon it before it’s complete. By informing your clients about the types of taxes they might incur, you'll build credibility and improve your client base.
Jorgen Rex Olson is a graduate of Washington State (B.A., cum laude, 2008) and the Indiana University (McKinney) School of Law (J.D., 2012). He writes for Mackay, Caswell & Callahan, P.C., one of the leading tax law firms in New York State.