Deferred Taxes

Deferred TaxesDeferred taxes is the outcome of Section 1031 of the Internal Revenue Code for taxpayers in certain qualifying situations. The rules on deferred taxes are very strict, but if they are met, the benefits can be substantial. Section 1031 allows a property owner to defer the federal and state capital gains tax that would typically be due at the time of the sale of the property until a point in time in the future if the proceeds and debt retired from the sale are equal to or greater in the replacement property.

Like Kind Requirement

In order to defer the capital gains tax via a 1031 exchange, the taxpayer must be holding both the property that is being sold (old property) and must intend to hold the new property being purchased (new property) in the productive use of a trade or business or for an investment. This rule means a taxpayer’s primary residence would not qualify for deferring taxes except in cases where the rental is converted to the primary then sold after the fifth year post acquisition. Another distinguishing feature for qualifying for deferred taxes is the stipulation that the properties being exchanged must be of like-kind to each other. Real estate will almost always be considered like-kind to each other. For example, a 16-unit apartment building would be of like-kind to a 3 tenant office building. Also, stocks, bonds, indebtedness and partnership interests do not qualify for deferred tax treatment.

45 and 180 Day Requirement

The taxpayer must follow two time frames in order to qualify for deferring the taxes. Before the sale of the old property, the taxpayer should identify that he/she will be completing a Section 1031 exchange to defer the taxes by including assignment language in the Purchase and Sale Agreement. Once the sale is complete, the taxpayer must identify the new property within 45 days post-closing and within 180 days of the closing of the old property, the taxpayer must complete the transaction for the new property. Extensions to these time frames are rare, and typically only happen in the case of a natural disaster as posted on the IRS website.

It’s important for the taxpayer to understand exactly what taxes are being deferred. The taxpayer is eligible to defer up to 100% of the federal and state capital gains and recaptured depreciation tax that would typically be due on sale until a point in the future. That time in the future would be when the property is sold and the exchange proceeds and debt retired is not re-invested using a 1031 exchange. Take this example:

Deferred Tax Example

Carl is going to sell his rental property that he purchased for $600,000, which he originally purchased for $500,000, and replace it with a like-kind rental property for $800,000. Carl is eligible to defer his taxes and has identified that he will complete a 1031 exchange. Carl would typically be responsible for a capital gains tax on the $100,000 gain he realized on the old property, but because he is re-investing 100% of the sales proceeds into a new property, he would be able to defer the capital gains tax. Let’s say the purchase price of the new property was lower than the sales price of the old property. Carl would only be able to defer the capital gains tax on amounts up to the amount that he re-invested and would be responsible to pay the taxes the following fiscal year on any amounts above and beyond.  

A taxpayer could technically initiate 1031 exchanges one after the other and continue to defer the taxes indefinitely. As long as the taxpayer continued to re-invest the proceeds and debt retired into new like-kind properties, he/she would be eligible to defer taxes until ultimately, death.

To learn “Ten Reasons Why a 1031 Exchange Makes Sense,” click on the button below and download the free three page eGuide.

Ten Reasons Why a 1031 Exchange Makes Sense