On a daily basis, we discuss the impact that capital gains tax law has on the strategic disposition strategies of our clients.
In our experience, the enormous tax burden that comes with the disposition of highly appreciated real property assets is the number one reason most owner/users and investors hold onto their properties for as long as they do. Many of you who own owner/user buildings have seen as much as a four-fold increase in your property’s value, a level you never contemplated when you acquired it. But, you refuse to sell despite recent changes in market and economic conditions that signal a potentially significant correction, mainly because of the tax implications.
You are not alone, as evidenced by the fact that the supply of owner/user buildings is still painfully low, even with the rise in mortgage interest rates we have experienced since the Fed slammed on the brakes.
Also of note is the fact that we find many building owners don’t know exactly how properties are taxed at the point of sale. They only know that is more than they are willing to pay. So, we thought it would be a good idea to provide a quick overview of the process just in case.
Calculating capital gains taxes is a three-step process. First, basis is adjusted. Second, gain is calculated and third, state and federal taxes rates are applied. Let’s take a closer look:
Step 1 – Adjusting Basis
We start with your Original Basis, which is what you paid for the property. Then we add the cost of capital improvements you have made to the property since you acquired it. Next, we subtract the depreciation you have taken over the life of the investment. The remainder is your Adjusted Basis.
Step 2 – Calculating Gain
In this step, we take the new sales price, subtract closing costs like commissions and escrow fees, and then subtract the Adjusted Basis from step 1. The remainder is your Capital Gain.
Step 3 – Calculating Tax Liability
There are three main taxes due, and potentially a fourth depending on your investor status. We’ll get to that in a minute. Now for the bad news. We usually start with the California state tax because the entire gain is taxed at ordinary income rates, which top out at 13.3%. Chances are you have a gain that will put you in that top bracket in the year you sell. Then we calculate your federal depreciation recapture tax, which is 25% of the total depreciation you took over the life of the investment. We then subtract the depreciation amount from the capital gain and tax the remainder at the federal capital gains tax rate of 20%. Add them all up and it comes out to roughly a third of your overall gain, depending on how much depreciation you took. In today’s world, the bulk of your gain is derived from appreciation, which in most cases is astronomical.
What about that fourth tax? That would be the Net Investment Income tax (aka the “Obamacare” tax) of 3.8% on passive investment income. If you are an owner/user or you qualify as a “professional” real estate investor as defined by the IRS, you will likely not be liable for this tax. Otherwise, you probably will be. You’ll need to seek guidance from a tax expert on this one to know for sure.
Considering the foregoing, it’s no surprise why so many property owners are reluctant sell even if what they would keep after taxes is more than they ever expected to get by orders of magnitude. It’s a form of procrastination that is easy to understand. However, the taxable event is inevitable unless your plan is to pass the property along to heirs via the step-up rule. Other than that option, it is only a question of when you pay taxes, not if. For an increasing number of owners we talk to, they are looking more at the two-thirds of their gain they’ll collect today versus the one-third they’ll hand over to the tax man.
So, what should you do? Our simple answer is this: it depends on what impact a sale would have on the quality of your life. For those of you at or approaching retirement age, that is a very important question. If pocketing millions in after-tax cash would be a game-changer for you, it may well be the way to go. We have written extensively on this topic. Please see our series on the Wealth Cycle for more on that. For you owner/users out there who don’t otherwise need a lump sum to execute your retirement strategy, holding the building and leasing it for rental income might be your best option. You will still be at risk as a property owner, but Orange County industrial real estate has outperformed other asset classes for decades. It’s up to you. There are also other options that we would be happy to discuss with you, as well.
So, if you are not quite sure, which fork in the road to take, maybe we can help.