To begin, I must make you aware that I am not an accountant or lawyer, so please seek tax advice from your consultants before moving forward with the acquisition or disposition of your investments. Its also clear that the fiscal-cliff bill, which was drafted over a long weekend by sleep-deprived politicians and then agreed to by what seems to be two very adversarial political parties, may only be a band-aid to the current issues facing the country and leaves many big issues unresolved.
If you currently have investments or are planning to invest in 2013whether its stocks, real estate, airplanes or even rare stampsyou must have an understating of capital gains tax. After all, whether you win or lose with your investments, the understanding of this convoluted part of the tax code can both soften your losses and sweeten your gains. Its apparent that todays debate over taxes, the fiscal cliff, the debt ceiling and who should be paying more taxes will most likely have an effect on the after-tax proceeds self-storage owners achieve when selling their property.
The New Rule
For the first time in recent history, the percentage a real estate investor will pay in federal capital gains tax will be tied to his household income. In 2013, households earning more than $400,000 ($450,000 if married and filing jointly) will see federal capital gains taxes increased from 15 percent to 20 percent. For most everyone else, capital gains tax rates would remain at 15 percent (the 0 percent rate is retained for taxpayers in the 10 percent and 15 percent tax brackets). Additionally, all capital gains taxes may now include the 3.8 percent Affordable Care Act net investment income tax also known as the Medicare Tax.
While no one likes paying higher taxes, the effects will be felt more by the higher-income earners wholl see an across-the-board tax increase for the first time in more than 20 years. Its worth noting, however, that a 23.8 percent capital gains tax is still in the bottom half historically, as noted in the accompanying chart. Since 1916, the capital gains tax rate has averaged 26.5 percent. With the tax increases now in place, the value of tax-deferral mechanisms, such as 1031 exchanges and cost segregation have never been greater. Its now time to learn the new rules of the game and start developing your strategies.
The tax code has long favored investment income over the money you get in your paycheck. But todays new tax code will leave little question to higher-income earners that investment income is more important. With federal capital gains tax rates topping out at 23.8 percent, its substantially lower than the top federal tax rate for ordinary income, which now sits at 39.6 percent.
In 2003, Congress set the top tax rates for both capital gains and dividends at 15 percent, lower than theyd been since the 1930s. Under the current tax plan, the top capital gains would be taxed at 20 percent, not including the 3.8 percent associated with the Affordable Care Act, which is a 33.3 percent increase. So nows the time to better understand the strategies available to maximize your investments.
Of course, its never a bad time to be rich. But its a worse time to be rich now because the new tax plan has clearly stated that the wealthier Americans will shoulder a bigger burden of the federal tax revenue. Despite these tax increases, one aspect of the tax code provides real estate investors with a huge tax advantage. A Section 1031 exchange allows real estate property owners holding property for investment purposes to defer taxes that would otherwise be incurred upon the sale of investment property.
Savvy investors use 1031 exchanges to redeploy their investment capital into better-performing investment properties while deferring capital gains taxes. The logistics and process of selling a property and then buying another are similar to any standardized purchase and sale, but a 1031 exchange is unique because the entire transaction is treated as a tax-deferred exchange and not just a simple sale. Its this difference between exchanging and not simply buying and selling which, in the end, allows the taxpayer to qualify for a deferred gain treatment.
To say it in simple terms, sales are taxable with the IRS and 1031 exchanges are not, unless consideration is received or debt is relieved. Its critical to remember that the capital gains taxes are only deferred and not eliminated when completing a 1031 exchange.
The foundation of a 1031 exchange by the IRS is that the properties involved in the transaction must be of like kind, and both properties must be held for a productive purpose in business or trade, or as an investment. The IRS also lays down a guideline for the proceeds of the sale. For example, the proceeds from the sale must go through the hands of a qualified intermediary (QI) and not through the sellers or their agent or the proceeds will become taxable.
Because the exchanging of a property represents an IRS-recognized approach to the deferral of capital gain taxes, its very important to understand the many components involved and the actual intent underlying such a tax-deferred transaction. Its also worth noting there are several very specific conditions one must comply with to complete a successful 1031 exchange. This includes the 45-day identification period, 180-day exchange period, and the purchase price of the exchange property must be of equal or greater value, just to name a few.
As mentioned earlier, self-storage owners are also allowed under the current tax code to use cost segregation to maximize the timing and amount of depreciation an owner can achieve to shield ordinary income from income tax. Accelerated depreciation has many details you must follow to successfully use this part of the tax code. The use of cost segregation to achieve accelerated depreciation is also simply a deferral of taxes and not a loophole that allows you to avoid paying taxes.
As investors in real estate, self-storage owners must continue to understand the ever changing rules that will allow them to maximize the return on their investments. They also must continue to seek the necessary experts in the industry who will help them develop the required strategies needed to navigate the evolving real estate investment world.
Ben Vestal is president of the Argus Self Storage Sales Network, a national network of real estate brokers who specialize in self-storage. Argus provides brokerage, consulting and marketing services to self storage buyers and sellers and operates SelfStorage.com, a marketing medium and information resource for facility owners. For more information, call 800.55.STORE; e-mail [email protected] To learn more about cost segregation and accelerated depreciation, visit www.argus-selfstorage.com .