Beginning in 2013, Internal Revenue Code (IRC) Section 1031 tax deferred exchanges will defer the recently elevated federal capital gains tax for taxpayers with a modified adjusted gross income (MAGI) of $200,000 for individuals and $250,000 for married filing jointly. The aggregate tax rate will increase from 15 percent to 18.8 percent for individual and married taxpayers with a MAGI of $200,000 and $250,000 respectively. For individual and married taxpayers with a MAGI of $400,001 and $450,001, the federal capital gains rate is 23.8 percent.
|Individual||Married||Capital Gains||Medicare Surtax||Aggregate Tax|
|$0 - $36,250||$0 - $72,500||0%||0%||0%|
|$36,250 - $200,000||$72,500 - $250,000||15%||0%||15%|
|$200,000 - $400,000||$250,000 - $450,000||15%||3.8%||18.8%|
|$400,001 +||$450,001 +||20%||3.8%||23.8%|
For taxpayers with a MAGI of $36,250 individual and $72,500 married, the federal capital gains rate is 0 percent. Individuals and marrieds with a MAGI of $36,250 - $200,000 and $72,500 - $250,000, the federal capital gains rate is 15 percent. In addition to the federal capital gains tax, many states impose a state capital gains tax and should the asset be depreciated, a 25 percent recaptured depreciation tax is triggered. Fifty percent first-year bonus depreciation was also extended for 2013 for personal property placed in service before January 1, 2014. The federal, state and recaptured depreciation tax outcome can result in a 40 percent tax of the asset’s sales price. The economic value of the 1031 exchange is the use of those otherwise paid tax dollars towards the replacement property as an interest free loan, continued depreciation offsetting income and appreciation potential.
IRC Section 1031 exchanges allow taxpayers to defer the gain or postpone paying the tax when property held in a trade or business or for investment is exchanged for property held in a trade or business or for investment. There are many rules to follow, with the first being the use of a Qualified Intermediary (QI) to facilitate the 1031 exchange. Anyone can become a QI, with the exception of what are known as disqualified persons, who are persons or entities considered to be an agent of taxpayer at the time of the exchange. This includes family members or related parties, including taxpayer’s employee, attorney, accountant, investment banker, broker or real estate agent.
1031 exchanges allow real property to be exchanged for any real property while personal property must be exchanged for like-class or like-kind personal property. Real property cannot be exchanged for personal property. US property can be exchanged for property located in the US while property held outside the US, such as India, can be exchanged for property held internationally or in India.
Primary Exchange Rules
Additional 1031 rules include that the exchange must be completed within 180 calendar days from the first closing. The net equity and or debt retired in the old property must be replaced with equal or greater net equity and or debt in the replacement property. Otherwise, a tax is triggered on the difference.
The taxpayer who sells is the taxpayer who buys.
Selling and acquiring property with related parties should be done with awareness of the related party rules requiring the related buyer to hold the property for two years, otherwise; the tax deferred is triggered. The related replacement property seller must also be initiating an exchange and cannot be cashing out per Revenue Ruling 2002-83.
Entities such as partnerships, corporations and multi member limited liability companies that want to own the replacement property in a different entity should consider changing the titleholder as far in advance of the closing as possible.
Replacement property must be formally identified to the QI no later than the 45th calendar day post-closing on the initial exchange leg. Three properties can be identified, regardless of value, or four or more given the aggregate does not exceed two hundred percent of the relinquished property sales price.
Revenue Procedure 2008-16 provides hold times for vacation properties or rental properties used for personal purposes. By following the two year hold time for both the relinquished and replacement properties, the IRS will not challenge whether the property is rented to others and occasionally used by the owner qualifies as property eligible for a 1031 exchange.
To learn more about 1031 exchanges and when one makes sense, click on the button below for the eBook “Ten Reasons When a 1031 Exchange Makes Sense.”
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