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Californians face some of the highest tax rates in the country, and most of the state's residents will proclaim that the benefits are well worth the costs.
When you sell something for more than you bought it, the amount of money you gain will be taxed -- capital gains tax.
You must report any profit made from selling something, both state and federal taxes.
When there's an assessment on the value of your investment when you've sold it, that will determine the amount of capital gains taxes you will need to pay. "Capital gains" are the value taxed on the profit made from the purchase price to the selling price.
Any investments you've made that have appreciated over time that you haven't sold are called "unrealized capital gains." This appreciation won't be taxed until the property is sold.
Short-term capital gains are for investments you've held for less than a year, while long-term capital gains are on investments held for over a year. In addition, long-term gains are typically taxed at a lower rate than short-term capital gains. The government encourages long-term investments.
It's a good idea to get some professional help while considering the tax implications of investing. Wise guidance from a tax preparer will help you make the best plan for handling your taxes and investments. Capital gains are taxed at different rates by the federal government and the State of California. Advice on the tax code will help you feel you're taking the best actions to protect your investments.
Real estate, stocks and bonds, and even crowdfunding investments can generate capital gains. For California, capital gains are taxed the same as ordinary income. Your tax bracket guides the federal government's tax rate for capital gains. Taxpayers must report any gains or losses from the sale or exchange of capital assets.
You will be taxed at 25% of all depreciation recapture, which applies to real estate and properties. Depreciation recapture allows for taxes to be collected on gains a taxpayer earns from the sales of assets.
Depreciation is often used to write off the value of an asset, allowing taxpayers to earn revenue from the asset's value and realize the benefit gradually. When an asset loses value, that represents its depreciation expense. If the value has decreased slowly over time, you can still earn revenue.
The federal capital gain tax rate of 20% was recently added to the tax code. Those who exceed the $400,000 taxable income threshold (for single filers) or $450,00 for married couples filing jointly will need to pay the higher tax rate.
The previous rate of 15% for federal capital gain taxes still applies to taxpayers who are below these income thresholds.
A 3.8% tax applies to taxpayers with a net investment income of more than $200,000 for single filers and $250,000 for married couples filing jointly. Net investment income includes interest, dividends, capital gains, retirement income, income from partnerships, and other types of unearned income.
California taxes capital gains as ordinary income and can vary from 1% to 13%. While some states have no state taxes, California has a top tax rate of 13.3%.
One strategy to limit capital gains taxes is by using 1031 Exchanges. Part of the IRS tax code, 1031 Exchanges allow you to defer taxes by exchanging "like-kind properties."
Properties that are investments or used for business purposes can be exchanged for other properties of similar value. This exchange enables you to sell properties while avoiding a significant tax burden. For example, you could exchange an apartment building for an empty lot, which you could later exchange for an investment in an ice cream stand.
The 1031 Exchange encourages reinvestment by taxpayers in their communities, helping to provide affordable housing and new business and job opportunities.
The Biden administration has proposed limitations to 1031 Exchanges as part of the 2023 budget. A deferral of capital gains up to $500,000 (or $1 million for married couples filing a joint return) would be recognized in the year the taxpayer transfers the property subject to the exchange. The change would increase revenue returned to the IRS.
Proponents of the measure say that the change wouldn't harm middle-class investors. But there is concern that wealthier investors will hold onto their properties and wait for more favorable changes. The proposal would dramatically limit the ability of investors to make improvements to properties and invest in their communities.
Based on Internal Revenue Service rules, a home you've lived in for at least two of the last five years is considered a primary residence. Therefore, profit from the sale of your primary residence is exempt from capital gains taxes.
But if your new home has a significant increase in value after only a year, and you sell it, you will need to pay capital gains tax. When you've owned your home for at least two years, meeting the primary residence rules, you may still need to pay taxes on any profits if they exceed thresholds set by the IRS.
You can exclude up to $250,000 of the profit if you're single. If you're part of a married couple filing a joint return, you could exclude up to $500,000 of the gain. This type of exemption is only allowed once every two years.
You can add your cost basis and costs of any improvements that you made to the home to the $250,000 if single or $500,000 if married filing jointly.
In your journey as an investor, you may find yourself owning property as an investment or property that produces income. However, you will need to pay taxes on your profit when you want to sell your property. A 1031 Exchange is a great way to lessen your tax obligations.
A 1031 Exchange allows you to exchange your property for another "like-kind" property. For example, if the property is held for income or investment in the United States, it can be considered like-kind. Using the 1031 exchange enables you to defer paying taxes on the sale. Some requirements need to be met to use a 1031 Exchange, so this is another occasion when professional advice is a good idea.
Only three kinds of property are eligible for a 1031 Exchange. You have to purchase a new property – you can't put in a property you already own.
You will need to understand the concept of "like-kind" to do a successful 1031 Exchange. "Like-kind" does not refer to the quality or grade of the property but rather its nature or character. The IRS regulations say that "all real property is like-kind to all real property." So, suppose you're selling property for which you possess a fee title. In that case, you can consider any other real property as a replacement.
If you have a farm to sell, you won't need to purchase another farm as a replacement – you might consider an apartment building or a strip mall. Other qualifying property types include oil and gas royalties from a ranch, a ski condo, residential, retail, commercial, or industrial rental properties. The property must function either as an investment or for productive business use.
You will need to find a qualified intermediary to act as your exchange facilitator in order to do a 1031 Exchange. Check with trusted attorneys, CPAs, or escrow experts for their recommendations.
A Delaware Statutory Trust is a vehicle for real estate investment. DSTs could give you access to commercial investment properties that are much larger than what you could buy on your own. DSTs can provide eligibility for 1031 Exchanges both upfront and upon exit. In addition, they could provide monthly income that's sheltered from income taxes.
DSTs are professionally managed passive investments. They can include many property types, such as apartment complexes, industrial buildings, self-storage, medical offices, or other commercial real estate. They are a good way for investors to diversify a portfolio, enabling them to manage their investment risks effectively without the stress of day-to-day landlord responsibilities. In addition, they can provide a monthly income with good tax advantages.
There are some types of possessions that you can't use for 1031 Exchanges. These include stock-in-trade, securities, or property held primarily for sale (such as a house you've purchased to flip). You also can't use stocks, bonds, notes, certificates of trust, or interest in a partnership. In addition, you can't exchange foreign real property for real property in the United States. Finally, you can't swap the goodwill of one business (considered intangible assets, such as reputation, intellectual property, or trade secrets) for the goodwill of another.
Your primary residence also can't be used for a 1031 Exchange, even if you've been working or running a business from your home.
Many would ask if their second home, or vacation home, could be used for a 1031 Exchange. Unfortunately, the short answer is that they can't.
But the IRS set a "safe harbor" rule in 2008 that says that if you do a 1031 Exchange to obtain a property you intend to use as a new second or vacation home, or even your primary residence, you can't move in right away. The IRS won't challenge whether the new property qualifies as an investment property for a 1031 Exchange if you meet some requirements.
You would need to rent the home at fair market value for a minimum of 14 days. Your home use can't be more than 14 days or 10% of the number of days during the 12 months that the home is rented at fair rental value.
1031 Exchanges are often done with real estate properties, but businesses can also be exchanged. However, you can't use vacant land you're holding for investment for a 1031 Exchange. If you buy a vacant lot intending to develop it and benefit from its sale after a tax-deferred exchange, it is not eligible. The IRS would consider your purchase of the vacant lot as intent to sell, not as an investment or for business purposes.
Using a 1031 Exchange to lessen capital gains tax might seem intimidating for new investors. Learning more about the practice could help build your confidence along with the value of your investments.
This article is for information purposes only. Talk to a CPA before making any final decisions.