In the US, we have different tiers or levels of taxation. Here is a brief explanation of some of those tiers, and a specific examination of capital gains taxes and rates.
Levels of Taxation
Ordinary income is typically the highest taxed level of income. Currently, this goes up to 39.6% at the federal level.
Other types of income have a more preferential or lower taxation. In particular, the sale of a capital asset, such as real estate that’s used for investment or business purposes, is taxed at a lower rate. Capital gains rates are at a max now of 20% in the US. Juxtapose that with an ordinary income tax payer who may be paying 39.6% in income taxes. So it’s a higher rate of taxation for earned income, compared to the sale of a capital asset.
The maximum deprecation recapture tax rate on the portion of the gain attributable to depreciation deductions taken over the years is 25% at the federal level. The tax code won’t allow taxpayers its most favorable capital gains rates on the portion of the gain relating to these prior depreciation deductions that were taken for the theoretical wear and tear on the property.
Net Investment Income Tax
On January 1, 2013, to fund the new health care laws, Congress created a new 3.8% Net Investment Income Tax (NIIT) as a direct new tax to fund the Affordable Care Act. This extra level of tax applies to taxpayers with net investment income above certain applicable threshold amounts.
The 3.8% tax applies to the excess of modified adjusted gross income over the following threshold amounts: ◦
- $250,000 for married filing jointly or qualifying widow(er) with dependent child
- $125,000 for married filing separately
- $200,000 in all other cases
So when you are selling commercial real estate or other property used in a business or for investment, even if you are eligible for the more preferential capital gains…tax can still be mind bogglingly high. So you want to defer your gains even if it’s at a lower rate by doing a 1031 exchange. That way you can defer, defer, defer, throughout your life. You can use that money that would otherwise go to the government in taxes and continue to compound and build your wealth over time.
- 1031 Hotline: If you have questions about capital gains, feel free to call me at 612-643-1031.
Defer the tax. Maximize your gain.
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