Should you sell your investment property or do a 1031 exchange?

You own real estate investment properties and are considering selling but want to know how to analyze your options.  Should you sell it outright and take the capital gains hit or do a 1031 exchange where you can defer the capital gains?

Here is an example:

Let’s assume a 25% tax bracket and a property with suspended losses of $20,000 and an appreciation of $20,000.  Obviously, if you do a 1031 exchange, there is no taxable gain, the suspended losses pass through to the new property and your new annual depreciation is based on the undepreciated cost of the old property plus any additional cash paid or increase in debt.

If you sell the property, you are taxed on the gain ($20,000 x 15% capital gain rate) of $3,000 but you get to deduct the $20,000 suspended losses at 25% – saving $5,000 in tax!  That equals a $2,000 tax savings and your depreciation starts over at the total cost of the new house.

In addition, for 2008 and 2009, if you have capital gain and you are in the 15% tax bracket or lower, the capital gain rate is zero, but the losses would still be deductible.

For investment properties in particular, it is wise to consult your tax accountant to determine the best options to meet your financial goals.