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Capital Gains demystified

Capital gains tax: what is it?

Capital Gains tax is one area of law that never ceases to perplex and anger taxpayers given that they already have a sizeable chunk of their income deducted via state and federal income tax.

A great deal of this anger can be directly attributed to the fact that most people are not especially well informed as to what exactly capital gains tax is or how it is calculated. This article provides an explanation of capital gains tax, more specifically, in the state of California. Reference is also made to the options available to the taxpayer to reduce this specific form of tax liability within the aforementioned state.

A capital gain refers to whenever a person disposes of (sells) an asset (which is not included in the exempted list) and where they receive a profit for their efforts. Just to make this issue as clear as possible, please consider the following:

A taxpayer purchases a home at $50,000 and sells it for $60,000. The capital gain in this scenario is $10,000 (although this figure would be reduced by virtue of a number of specific expenses such as legal fees). If however the figures were reversed, then no capital gains tax liability would be incurred at all.

Capital gains in California

If you live in California and are looking for some exciting new investment opportunities with which you can strike out and make your fortune then you are in luck. Not only does California have extremely competitive median house prices, but the capital gains liability that a taxpayer will incur with the disposal for profit of a qualifying asset has a number of effective tax avoidance provisions for the savvy taxpayer.

The Exchange 1031: your tax reduction friend.

Of these, the most popular and effective is the so called "Exchange 1031". What exactly is an Exchange 1031, and how does it work?

If a taxpayer sells real estate and uses the proceeds of that sale to purchase "like property" (a legal definition provided for by the IRS) then the full value of the capital gains liability for the initial transaction will be deducted from the purchase price of the new property. The qualifying conditions which must be satisfied for an Exchange 1031 to be used are as follows:

  • The value of the additional property which is being bought with the profits earned from the initial sale must be equal to, or exceed the level of (net) profits which the taxpayer made when they sold the initial property.
  • The entire value of the equity which was earned as a result of the initial transaction must have been used whenever the additional property is being purchased.
  • If there is a difference in the purchase price of the replacement property which is due to be, or has been purchased under the provisions of an Exchange 1031, to the net profits that were realised with the sale of the initial property, then the taxpayer is liable for an "accrued tax liability".

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