There are many advantages and reasons for taxpayers to initiate a 1031 exchange when selling real and personal property productively held in a trade, business or for investment. The primary advantage is the deferral of federal and state capital gain and depreciation recapture taxes that can represent 40 percent of the relinquished or old property sales price. The deferral represents an indefinite interest free loan that is used as additional working capital to acquire the replacement property. The tax obligation does not go away, but rather is postponed until the replacement property is sold. The taxpayer can initiate any number of 1031 exchanges to continually defer the tax until death.
Tax Deferral Strategy
Over ninety years ago, the 1031 exchange tax deferral strategy was passed into law on the premise that the taxpayer is left in the same tax position as if the relinquished property never sold. The taxpayer has not received an economic benefit either in cash or reduction in debt. Partial exchanges are acceptable; however, a tax is triggered on that portion of the equity or debt relief received.
Internal Revenue Code Section 1031 states “no gain or loss shall be recognized on the exchange of property held for productive use in trade or business, or for investment, if such property is exchanged solely for property of like kind which is to be held for productive use in trade or business or for investment.”
Relocation and Asset Transition
Many taxpayers wish to relocate their investments for a variety of reasons such as life changes. Taxpayers owning vacation properties will typically want to live in the same geographical region to visit or perform annual maintenance. Selling a condominium in Destin, Florida and replacing for a rental unit in Charleston, South Carolina is an example.
Businesses use the 1031 exchange to shift to more productive property or adjust to business challenges. The 1031 exchange allows a construction company to replace a piece of equipment that is no longer in use or is near the end of its useful life with equipment in the same asset classification. Businesses with fleets of cars and trucks use 1031 exchanges to upgrade their fleets. Timber companies, such as Weyerhaeuser, Rayonier, and Plum Creek use 1031 exchanges to transition from poorly performing timber or timber located far from their lumber mills to better producing timber tracts and closer proximity to their company mills.
Farmers and ranchers utilize the 1031 exchange to replace agricultural equipment that is technologically advanced, achieving greater production efficiencies. The 1031 exchange encourages conservation as demonstrated by farmers restoring row cropped fields to wetlands, preserving natural habitat.
Consolidation, Diversification and Cash Flow
A taxpayer acquiring multiple investments may wish to consolidate. If the taxpayer owns a property that has appreciated, they may want to diversify into many properties. Taxpayers owning land may want to diversify into cash flowing properties such as an apartment or single family residential.
Borrowing Power and Leverage
A 1031 exchange enables the taxpayer to use those otherwise payable tax dollars as additional working capital to acquire bigger properties. The taxpayer’s ability to borrow is enhanced because more capital is available for the purchase encouraging investors to increase their investments.
Depreciation
Another advantage of a 1031 exchange is that it allows a taxpayer owning non-depreciable property, such as land, to exchange for depreciable replacement property. This allows the taxpayer to offset their income with depreciation. When the property is sold, the 1031 exchange allows the 25 percent depreciation recapture tax to be deferred.
The 1031 exchange is an Internal Revenue Service accepted method to defer federal and state capital gain taxes, providing liquidity to the transaction to buy and sell like kind property held for the proper intent.
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