Tax Consequences of Selling Without a 1031 Exchange
If you sell an investment or business property without using a 1031 exchange, you may owe several types of taxes on your capital gains. The exact amount depends on factors such as the length of ownership, depreciation, and state tax laws.
1. Capital Gains Tax on a Property Sale
If you sell your investment property for more than you paid, you owe capital gains tax on the profit. The tax rate depends on how long you owned the property:
Long-Term Capital Gains Tax (Owned for More Than One Year)
For 2023, the federal long-term capital gains tax rates are:
- 0% – Taxable income up to $44,625 (single) or $89,250 (married filing jointly).
- 15% – Taxable income between $44,626 – $492,300 (single) or $89,251 – $553,850 (married filing jointly).
- 20% – Taxable income above $492,300 (single) or $553,850 (married filing jointly).
Short-Term Capital Gains Tax (Owned for One Year or Less)
If you held the property for one year or less, your profit is taxed as ordinary income, which can be as high as 37%, depending on your tax bracket.
2. Depreciation Recapture Tax
If you claimed depreciation deductions on your investment property, you will owe depreciation recapture tax upon sale.
- Depreciation recapture is taxed at 25%, regardless of your income level.
- Example: If you claimed $100,000 in depreciation, you will owe $25,000 in depreciation recapture tax.
3. Net Investment Income Tax (NIIT)
If your adjusted gross income (AGI) is above certain limits, you may owe an additional 3.8% Net Investment Income Tax (NIIT) on your capital gains.
NIIT Income Thresholds for 2023:
- $200,000 (single filers)
- $250,000 (married filing jointly)
This tax applies to the lesser of your net investment income or the amount by which your AGI exceeds the threshold.
4. State Capital Gains Tax
Many states also tax capital gains, and the rates vary:
- California: Up to 13.3%
- New York: Up to 8.82%
- Texas & Florida: 0% (No state income tax)
Check your state’s tax laws to determine how much you may owe.
Example:
How Much Tax Would You Pay Without a 1031 Exchange?
Let’s say you sell a rental property for $1,000,000 that you originally purchased for $600,000. You claimed $100,000 in depreciation, and your taxable income is $300,000 (married filing jointly).
Tax Calculation:
- Capital Gain:
- $1,000,000 – $600,000 = $400,000
- Taxed at 15% (federal long-term capital gains) = $60,000
- Depreciation Recapture:
- $100,000 taxed at 25% = $25,000
- Net Investment Income Tax (NIIT):
- $400,000 x 3.8% = $15,200
- State Taxes (California at 9.3%):
- $400,000 x 9.3% = $37,200
Total Taxes Owed Without a 1031 Exchange:
$60,000 (federal capital gains) + $25,000 (depreciation recapture) + $15,200 (NIIT) + $37,200 (state tax) = $137,400
Why Consider a 1031 Exchange?
If you don’t use a 1031 exchange, you could owe:
-
Federal capital gains tax
(up to 20%)
-
Depreciation recapture tax
(25%)
-
Net Investment Income Tax (NIIT)
(3.8%)
-
State capital gains tax
(varies by state)
A 1031 exchange allows you to defer these taxes by reinvesting the full proceeds into another like-kind investment property. Always consult a tax professional or financial advisor to minimize your tax liability and explore your best options.
