1031 Exchange

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Considering a 1031 exchange? Then you most likely have evaluated the tax consequences and determined that the tax deferral of capital gains makes sense. As a Qualified Intermediary, clients tell me the primary reason they initiate a 1031 exchange is the ability to defer the taxes. In addition, they have a new asset to depreciate, either real or personal property, offsetting federal income taxes. Another reason is the new asset is more in line with the characteristics of their core holdings.

1031 Exchange

A 1031 exchange is when one property is exchanged for another. Land is exchanged for an oil or gas royalty or farmland is exchanged for a vacation rental property with limited personal use.  Any type of real property is exchangeable for any type of real property. Personal property such as heavy construction equipment can be exchanged for like-kind or like-class equipment. The intent must be to hold the property in a trade, business or investment and not for predominantly personal use. Property held in the United States is not exchangeable for property held overseas.

The outcome of a 1031 exchange is a tax deferral. The Internal Revenue Code Section 1.1031 states that no gain or loss is recognized, meaning that when the taxpayer files their federal return, the recognized gain or tax triggered when the property is sold is not due. The tax obligation has not evaporated, but is postponed until the replacement property is sold. When the taxpayer files their federal tax return, the tax on the replacement property and the original tax deferred are due unless another 1031 exchange is initiated.

Tax Implications

The taxes eligible for deferral are those triggered when the property is sold. The taxes include federal and state capital gains tax (Alaska, Florida, Nevada, South Dakota, Washington and Wyoming do not assess a state capital gains tax) and recaptured depreciation. The taxes as a whole can represent close to 40% of the sales price.

The recognized gain is determined by adding items 3, 4 and 5.

1. Original Sales Price + Improvements – Depreciation Taken = Adjusted Basis
2. Sales Price – Adjusted Basis –Selling Expenses = Realized Gain
3. Federal Long Term Capital Gains Rate x (Realized Gain – Depreciation Taken) = Federal Capital Gains Tax
4. State Capital Gains Rate x Realized Gain = State Capital Gains Tax
5. Depreciation Taken x 25 percent = Recaptured Depreciation

Deferring the gain and using it towards acquiring replacement property is effectively an indefinite, interest free loan.

The tax is ultimately paid at the then current federal and state capital gains rate or when the taxpayer dies and the property is given to the beneficiaries. The property basis is stepped up to the heirs, meaning that if the property is then sold and not replaced, there is no capital gains tax. If sold later, then if the property appreciates, there will be a tax on the gain but only from the comparable gain when it was received, not the original purchased price.

The capital gains tax can also be eliminated if a property held as a rental is converted to a primary residence and then sold after holding it for five years, with at least two of those as the taxpayer’s principal home. The $250,000/$500,000 taxpayer exclusion provided by Section 121 can eliminate the capital gains tax of the properties held as a rental, given the gain is less than the exclusion when sold.

To learn more about tax deferral strategies, read

• Deferred Sales Trust: Alternative to 1031 Exchange
• Tax Implications Converting 1031 Rental to a Primary Residence
• Three Like Kind Exchange Benefits.

Call our office at 800.227.1031 or request a complimentary consultation.