Upon the sale of real or personal property held in a business or for investment, the seller is subject to a hefty capital gains and recaptured depreciation tax which would be due upon the sale on the realized gain over the original purchase price. Though capital gains tax is excludable up to $250,000 or $500,000 for property owners selling their primary residence once every two years per Section 121, for an investor selling real or personal property, it is possible to defer the tax with a 1031 like kind exchange. A 1031 like kind exchange is a fairly complex transaction that can be a great benefit to the property owner if done correctly.
Andy Gustafson
Leasehold Improvements
When a taxpayer sells property outright, the sale is often subject to the payment of capital gains taxes. To avoid the payment of capital gains taxes, a taxpayer may choose to enter into a Section 1031 Exchange instead of a traditional sale. If the transaction qualifies for Section 1031 treatment any applicable capital gains tax will be deferred. The basic premise of a Section 1031 Exchange is that the taxpayer will relinquish a property and replace it with another property of “like-kind”. While there are a number of other criteria that must be met for a transaction to qualify as a Section 1031 Exchange, the “like-kind” criterion itself has been the subject of much debate over the years. For example, can a leasehold interest exchanged for a fee interest ever be considered a “like-kind” exchange?
2013 Surging Housing Market and 1031 Exchanges
The current investment property real estate market and 1031 exchange surge is reminiscent of the housing market in 2006. Is it that long ago that we don’t remember the housing market depression caused by the mortgage backed securities or mortgage derivatives and related string of Wall Street bail outs, foreclosures and short sales? Word from Investment Realtors is that we are in a Seller’s market where multiple Purchase and Sale Agreements are received within days of listing properties. But is that really true? Multiple clients report that their properties are not selling, but that could be that location continues to be a critical component in the number of days a property is on the market.
Disregarded Entity and 1031 Exchange
Often times, a taxpayer will choose to hold his/her investment property in the name of a disregarded entity or single member limited liability company (SMLLC), which allows the owner to be taxed on their personal tax return. The intent is that the owner’s personal liability is protected because the title of the property is held in the name of the SMLLC. Determining the merits of owning property in a SMLLC should be discussed with your tax and legal advisor.
1031 Exchange
A disregarded entity may still enter into a 1031 exchange and reap the benefits of deferred capital gains tax. When the owner is simply a single person, the process is quite simple. The same taxpayer requirement applies for a disregarded entity as it would if the property was owned in the name of the individual. The taxpayer who sells is the taxpayer who must acquire, with the exception of a disregarded entity. If held as a disregarded entity, then the taxpayer may acquire the replacement property or vice versa. The properties being exchanged must be held for investment or for trade or businesses, they must be of like-kind to one another, and the complete exchange must occur within 180 days of the sale of the old property. To defer the realized gain, the replacement property must be equal to or greater than the relinquished property, otherwise the difference is taxed.
Example: John holds his investment property, which he is selling for $200,000, in the name of an SMLLC for liability purposes. He acknowledges that he will be completing a 1031 exchange. John may purchase the replacement property as an individual or in the name of the disregarded entity. The new property’s purchase price is $250,000. Any capital gains tax that would be due from the sale may be deferred because John or the disregarded entity is re-investing 100 percent of the sales proceeds into the new property.
Drop and Swap
Taking the disregarded entity a step further, a 1031 exchange can carefully be completed with a multiple member limited liability company (MMLLC). Sometimes partners in an investment may disagree on the use of the proceeds from the sale of their shared interest. One partner may want to complete a 1031 exchange and re-invest the proceeds with no capital gains tax, while the other may want to cash out and move on. The so-called “drop and swap” can be an option in this situation. Prior to the sale of the old property, the partnership of the MMLLC will be dissolved and will distribute the property as tenant in common interests to each individual member. This is the “drop” in the transaction because the MMLLC is dropping to individual’s names. The sales contract needs to be entered into as tenants in common. Because the ownership structure is now tenants in common, upon the sale of the old property, one partner may exchange his/her interests into a replacement property, while another partner may decide to cash out and be liable for the capital gains tax.
A “drop” and “swap” can have its risks. Dropping the property to tenants in common status should be done a year in advance to ensure that the property will qualify for 1031 status. This is not a hard-and-fast rule, but the Internal Revenue Service (IRS) will likely look more closely if the drop occurred less than 12 months prior to the sale. Another aspect the IRS will potentially put a microscope to is the operation. Once the “drop” occurs, any activity must follow that of tenant in common interests and not as a partnership. Once again seek the counsel of your tax advisors to understand the tax consequences and risks.
Disregarded Entity
The primary reasons to hold property in a disregarded entity are protection of personal assets and reduced tax filing expense using Schedule C by the taxpayer. A subchapter S corporation is not considered a disregarded entity though the taxpayer is taxed on their personal return filing IRS Form 1120-S. A partnership is not a disregarded entity nor is a multi member limited liability company. A corporation is a separate entity from the taxpayer and is not a disregarded entity. The disregarded entity is ignored for federal and many state income tax purposes.
We Can Help
Atlas 1031 Exchange has been accommodating tax-deferred exchanges of all kinds for more than 17 years. We are fluent in the rules and regulations of IRC Section 1031 and able to help you navigate your exchange.
Contact us today to discuss any questions you may have. Call our office at 1-800-227-1031, email us at info@atlas1031.com, or submit your question through the online form at the top of this page.
Capital Gains in a 1031 Exchange
In the United States, upon the sale of property, a taxpayer generally must pay a capital gains tax on the realized gain, which in some cases can be in upwards of 40 percent of the realized gain. The realized gain is determined by the difference between the original purchase price of the property, plus capital improvements less depreciation and the selling price less the selling expenses. With such a high potential capital gains tax, in can often bring in to question whether the sale of the property will end up being profitable or not.
IRC Section 1031
Under Section 1031 of the Internal Revenue Code, investors may defer capital gains tax realized on the sale or exchange of property if the property is held for business or investment purposes and is like kind. Strictly speaking, Section 1031 is not reserved for real estate; however, it is most frequently used in the transfer of one real estate property for another. To better understand a 1031, there are a few things of which to be aware.