Owing more in tax than what you received from sale.
You may wonder how some people end up with a tax bill that is larger than the amount of cash they take home from the sale of their property. Or maybe this is your current circumstance and you don’t know how you got here. We’d like to take a moment to offer an explanation of how this is possible so that you don’t find yourself in this unfortunate circumstance.
Furthermore, we’ll show you how a 1031 exchange can be a solution that may save you from having to withdraw from your 401K to pay your taxes.
So how does one end up here? We’re all aware that capital gains taxes will be owed on any profit made from the sale of a property. For a more complete explanation on how capital gains taxes are calculated read our explanation here.
To be clear, capital gains are not:
- The amount the property is sold for,
- The amount of cash you put in your pocket after the sale,
- The difference between the appraisal amount and the sale amount,
- The amount remaining after loans are paid off, or
- The difference between the purchase price and the sale price.
Instead, capital gains, at a basic level, are:
- The sales price
- Less the costs to close the sale
- Less the costs basis of the property (purchase amount + costs of upgrades – accumulated depreciation)
- Equals Capital gains
Depending on the short-term or long-term nature of your investment in the property and whether or not self employment taxes will factor in, you could be taxed as low as 15% on your capital gains or as high as 40%. The time that you owned the property is not the only factor that determines whether you will be taxed at long-term or short-term rates. Therefore, it is vital that you work with a tax consultant prior to buying a property and at the time of selling to determine how much capital gains taxes will affect your real estate investment.
You may be thinking that even if an investor does owe 40% of their capital gains to the IRS, they still have 60% of the gains to deposit into the bank, right? Not always.