If you are a tenured investor who has built a portfolio of diverse properties, a 1031 exchange is an exceptional tool to assist in continuing to add to, diversify or consolidate your holdings. A common misconception exists around 1031 exchanges that a single investment property must be exchanged for a single like kind investment property. This is incorrect. In fact, the ability to trade a single investment property for multiple properties, or in reverse; multiple properties for a single property gives the savvy investor the flexibility to adjust their portfolio according to their needs.Read More
Given the asset sale is a taxable event and the taxpayer’s intent is to replace with a like-kind asset, a 1031 tax deferred exchange results in the efficient use of the dollar through economies of scale. Maximizing the marginal use of the dollar is the core principle in a 1031 tax deferred exchange, rather than paying the capital gain tax. Economies of scale is a microeconomics term used to describe reductions in unit cost as other cost contributing factors decrease. Relative to a 1031 exchange, the cost of capital decreases as the return on capital may increase over time.
As a general rule, anytime you sell property, the gain you receive as a result of the sale is subject to capital gains taxes. For example, if you purchased a property five years ago for $100,000 and now wish to sell it for $150,000, you would be subject to paying capital gains taxes on the gain of $50,000. One strategy that allows you to defer capital gains is to enter into a 1031 Exchange. Section 1031 of the Internal Revenue Code can provide an effective mechanism for deferring the payment of payment of capital gains taxes if the 1031 exchange guidelines are followed.
For those not familiar or a bit rusty, this article looks at the 1031 exchange definition including what, when, why and how of Internal Revenue Code (IRC) Section 1031 tax deferred exchanges. The Internal Revenue Service refers to 1031 exchanges as tax-free exchanges because the outcome in the year a 1031 exchange concludes is that no gain or loss is recognized meaning that no tax is paid.
When selling a capital asset, it is critical to include the tax consequences of the transaction in the decision making process. Three taxes are typically triggered when a capital asset is sold including federal and state capital gain and recaptured depreciation. These taxes can represent upwards of 40% of the sales price and more if the asset is held less than one year. Such states as Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington and Wyoming do not have a state capital gains tax but federal capital gain and recaptured depreciation taxes will still apply to the sale. A 1031 exchange allows deferring the above-mentioned taxes until the sale of the replacement property.
Timberland owners often engage in tax deferred exchanges to save funds for higher yield acquisitions. Along with timberland, timber rights held for either business use or investment can also be exchanged and capital gains deferred for real property given proper conditions. Timber rights holders willing to maximize their benefits through such exchanges should pay close attention to state regulations and transaction structures in terms of cutting time and timber quantity limits.
The Consumer Financial Protection Act of 2010(CFPA) was recently signed into law that will provide regulation for Qualified Intermediaries (QI) of 1031 tax deferred exchanges. The Federation of Exchange Accommodators (FEA) is a trade association representing companies whose primary business is acting as QIs for 1031 exchanges. The FEA will work with the Consumer Financial Protection Bureau to draft regulations. In 2007, the FEA had asked the Federal Trade Commission to govern QI’s but the Commission declined citing the burden of oversight exceeded the benefits.
Recently, the New Hampshire Governor signed Senate Bill 483 into state law. This is a significant event in the 1031 exchange world especially as states look for revenue generating sources.
Effective March 10, 2008, the Internal Revenue Service (IRS) instituted Revenue Procedure 2008-16 providing clarification when a vacation home is and is not eligible for 1031 consideration. For years this was a gray area. Unfortunately, without the IRS guidance, the rules were subject to interpretation which led to abuse.