Deferred Gain
Posted by Andy Gustafson on Thu, Jan 26, 2012
Deferred gain is the postponement or delay of paying the recognized gain. Recognized gain is the tax triggered when an asset is sold and determined by imputing the appropriate federal and state capital gains rate and recaptured depreciation tax rate of 25 percent on depreciation taken. Recognized gain is the tax paid on the realized gain.
Realized Gain
Realized gain is the value in dollars given the purchase price and the selling price. Realized gain is determined by a simple formula:
Original Purchase Price + Improvements – Depreciation Taken = Adjusted Basis
Sales Price – Adjusted Basis – Selling Expenses = Realized Gain
Risk Reward of Deferred Gain
Risk
The risk of deferred gain is dependent upon the current capital gain tax rates and value of the property. For example, the current long term federal capital gains rate is 15 percent. The rate is scheduled to increase to 20 percent, effective January 1, 2013, along with an additional 3.8 percent for those taxpayers earning greater than $250,000. Both the federal and state capital gains rates can change. If the rate is higher in the year the property is sold, the tax will be higher. If it is lower, less tax is paid.
The second risk of a deferred gain is if the property value declines. In the real estate decline post 2005, many properties acquired before 2004 are currently priced lower. If sold, there most likely would not be a gain due to lack of appreciation, but instead a loss. If there is a mortgage or loan on the property, the sales price could be lower than the mortgage. The lender may hold the taxpayer accountable for the difference and if the deficiency is removed, the Internal Revenue Service may impose a tax on the debt relieved.
Reward
The reward of deferred gain is the tax is not paid until another milestone. In a 1031 exchange, the deferred gain is not due until the replacement property is sold. The time held represents the reward, or use of those otherwise paid dollars as an interest free loan.
For example, in a 1031 exchange where a property is sold for $200,000 with a recognized gain or tax of 30 percent, the $60,000 represents an interest free loan. As long as the $60,000 is used towards the purchase of replacement property of equal or greater value, the taxpayer can use the $60,000 interest free. Plus, no loan documentation is required. At 5 percent interest over five years, a deferred gain saves $7,910.68 in interest.
Sales Price = $200,000 Recognized Gain or Tax of 30 percent = $60,000
5 percent interest over five years on $60,000 = $7,910.68
There are other reasons to consider deferring gain, depending on the intent of the taxpayer. If the proceeds of the sale are not needed until later, the gain can be deferred indefinitely while the net equity from the sale earns income in a Deferred Sales Trust. If the taxpayer wants to acquire a replacement property in a 1031 exchange, the gain is deferred until the replacement property is sold.
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