1031 Exchanges and the 3.8% Net Investment Tax – IRS Section 1411 regs

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1031 tax deferred exchanges under IRS section 1031 of the Internal Revenue Code allow real estate investors to defer taxes that would be due if the property was sold instead of exchanged.

If the investor decides not to participate in a 1031 exchange, the taxes potentially and likely owed would include the following:

A) depreciation recapture at 25%;

B)  the applicable Federal capital gain tax rate.  If the tax payer falls within the 10% or 15% marginal income tax brackets, then the long-term capital gains tax rate is 0%.  At the 25%, 28%, 33%, or 35% marginal income tax brackets, the long-term capital gains tax rate is 15%.  At the 39.6% marginal income tax bracket, the long-term capital gains tax rate is 20%.

C) The applicable state tax rate (0% – 13.3% depending upon the state tax rate)

D ) In addition, the capital gains of high-income earners are subject to a net investment income tax of 3.8%, above and beyond that capital gains tax rate. Those rates kick in at $125,000 if the taxpayer is married filing separately, $200,000 if single or as a head of household, or at $250,000 if married filing jointly or a qualifying widow(er) with a dependent child. (Recaptured depreciation is taxed at a maximum of 25%.)

The new and higher tax rates in 2013 resulted in an approximate 50% increase in 1031 exchange activity. Late last year, on November 27, 2013, the IRS issued final and proposed regulations giving guidance on the application and computation of the 3.8% net investment income tax imposed by Section 1411.

To read the final regulations, click on T.D. 9644 and REG-130843-13