Capital gains taxes and equity are two real estate concepts that are sometimes misunderstood. In short, capital gains refers to the increase in value of a property and equity refers to the amount of a property that you actually own as opposed to the amount you have financed.
Cost Basis: When you purchase a property, you pay an established, contractual price for it, and the purchase will typically be either all cash or all financed or some combination between the two. Your cost basis is the total cost of the property plus any costs incurred during acquisition such as real estate agent commission and mortgage fees. If you pay all cash then your cost basis and your equity in the project will be roughly equal.
Depreciation: In order to gain a tax benefit while owning a property used as an investment, you can depreciate it each year. Residential and multifamily rental properties are depreciated over 27.5 years and commercial properties are depreciated over 39 years. Whatever amount of depreciation has been recognized during the time frame the property is owned is deducted from the cost basis, but not from your equity. You may only depreciate the value of “improvements” on the property, such as buildings, landscaping, roads, etc. You cannot depreciate the value of the land. In Silicon Valley, the value of land is usually 70-75% of the value of a property, therefore depreciation tax shelter is much smaller on a percentage basis than other areas of the country where land value is more like 25-40% of the value of a property.
Capital Gains: When you sell the property, to calculate capital gain, you subtract the cost basis minus recognized depreciation from the sales price. Capital gains may be taxed depending on your situation. In California, for example, the capital gains tax rate is 15- 23.8% to the IRS, up to 12.3% the State of California, and 25% of any depreciation you took on your tax return over the years you owned the property. You can see that the capital gains tax rate in California will roughly total between 30% and 40%. Most investors choose to perform a 1031 exchange to defer this tax bill at the close of sale.
Equity: Your equity in a property is simply the calculated by the current value of the property minus the existing debt secured by the property. This can fluctuate over time based on the rise and fall of real estate values in your area.
Equity Upon Sale: When you sell your property, if you own 100 percent of it, all the proceeds will come to you as equity. If you have a mortgage, the proceeds from the sale will be applied to pay off the mortgage first and the remainder will come to you as equity after selling expenses.
1031 Exchange: If you perform a 1031 exchange when you sell investment property, all taxes will be deferred as long as all proceeds from the sale are reinvested in real estate that is held for investment purposes. This would include rental property and raw land. You may 1031 exchange all or part of your proceeds, and only the amount that is not put through the 1031 exchange process will be subject to capital gains tax.