A look at how to approach selling a highly appreciated asset, the taxes involved there-within, and the impact of current market conditions.
Making the decision to sell a highly appreciated asset is not easy.
The very thought of writing huge checks to the IRS and the Franchise Tax Board is enough for most property owners to dismiss the idea of cashing out. Some opt for a hold-forever approach instead, while others exchange into other real estate assets to defer taxable events. Both those options have their place depending on individual circumstances, estate planning strategy and where the investor is in what we call “The Wealth Cycle”.
However, planning a real estate strategy around an aversion to taxation has potential drawbacks.
Values in every asset class run in cycles as numerous economic forces move pricing higher or lower. Individual investors have no control over macro-economic metrics, only their response to them.
Some sell before a perceived market peak to assure themselves of a tidy profit. Others hold on too long in hopes of maximizing profits, and find themselves chasing the market in the wrong direction by selling during a correction.
The truth is that nearly all real estate dispositions have significant tax consequences, even for assets sold with little or no capital gain. At minimum, the IRS will impose a 25% recapture tax on depreciation taken during the hold period.
Add federal capital gains taxes of 20%, the 3.8% Obamacare tax on investment income and state income tax as high as 13.3%, and it becomes easy to see why so many investors make the tax-driven decision to hold their assets. How could it make sense to do otherwise with such a heavy tax burden?
While a properly executed IRC 1031 exchange can defer all taxes on a disposition, it requires an acquisition of another like-kind asset of equal or greater value. If the up-leg property is also highly appreciated due to the same macro-economic conditions, then the investor’s equity is just as much at risk, unless the property has greater appreciation potential due to its location, quality or functionality.
There are a lot of Orange County industrial property owners wringing their hands over what to do. On the one hand they see property values continue to rise, but on the other they know that every day brings them one day closer to the next correction. Those prone to brinksmanship are holding on while those with a more critical eye on capital preservation are deciding to sell despite the tax consequences.
To assess your own situation it might be helpful to ask yourself what you will keep after taxes are paid rather than what you will pay in taxes if you sell. When a property is sold outright, taxes are paid and basis is reset.
When a property is exchanged, the basis from the down-leg property follows the investor, which defers but does not reduce the eventual tax bill. Holding on maintains your exposure to a market correction, but also offers the potential for further appreciation.
Here’s another way to look at the tax issue.
In the last several years, industrial property values have been rising at a double-digit annualized pace. As a result, if you sold your property outright under current market conditions, all the federal and state taxes due would probably be covered by just the last two year’s increase in your property’s value. The rest would be yours to enjoy.
Could values still move higher? Yes. Could they move lower? Yes. The one thing we know for sure is: if you sold your property today, it would probably set a new record.
If you’d like to see a financial model of the benefits and consequences of selling your property, we can help. Just give us a call.
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