Taxpayers selling and replacing real and personal property held in the productive use of a business or investment utilize a 1031 exchange or Internal Revenue Code Section 1031 to defer federal and state capital gains and depreciation recapture taxes. Taxes that represent upwards of forty percent of the sale can be used to acquire the replacement property. In effect, the 1031 exchange is an indefinite, interest free loan. The taxes are ultimately due when the replacement property is sold and the taxpayer cashes out.
Capital Gain
Capital gain is the net gain (realized gain) between the selling price less the adjusted basis less selling expenses. The adjusted basis is determined by the original purchase price plus improvements less depreciation. A capital gains tax is triggered when the property sells and ownership is transferred to the buyer. If the property is held for less than one year and a day, the gain is considered short term and is taxed as ordinary income. If the property is held for more than one year and a day, the gain is long term and taxed at a lower rate dependent upon the federal filing status as either an individual or married filing jointly and adjusted gross income.
Effective January 1, 2013, the following capital gain rates were implemented.
How to Determine Recognized Capital Gain
Once the realized gain is determined, the taxes are assessed. Deprecation recapture represents a tax of 25 percent on the depreciation taken or not. If the state where the taxpayer resides has a state capital gains tax, the rate is assessed on the total realized gain. Some cities and counties have a capital gain tax rate that also needs to be applied to the realized gain. Next, subtract the depreciation from the realized gain and apply the federal capital gain rate. Total the taxes due to determine your estimated recognized gain. Confirm with your CPA to check whether there may be a loss carry forward that could offset some of the gain.
1031 Exchange
In a business, the assets are typically real and personal property, inventory and good will. The latter two are not eligible for 1031 consideration. Should the business owner’s intent be to sell and replace the real and personal property in an amount equal to or greater than the property’s selling price, a 1031 exchange should be considered. Real property can be exchanged for any real property given the location is in the US. Property held internationally is also eligible for 1031 treatment given the replacement property is also held outside the U.S. Personal property must be exchanged for “like-kind” personal property or within the same class of asset as defined in either one of thirteen General Asset Classes or North American Standard Classification System (NAICS).
An individual taxpayer, husband and wife, trust, limited liability company and corporation can also initiate a 1031 exchange when selling real or personal property. Examples of personal property include aircraft, construction equipment, trucks, radio and TV licenses, hospital equipment, gold and silver bullion, thoroughbred show horses, vintage and classic cars and franchise rights. Real property can be land, single family residential, vacation rental properties, commercial, oil and gas royalties, easements and leasehold interests held by the lessee for greater than thirty years.
The first step in a 1031 exchange is to ask your CPA, “What is the tax consequence of selling the property?” The second question is whether or not the taxpayer wants to acquire replacement property of equal or greater value. If the replacement property value is not equal or greater, ask what the tax consequence of the difference is, known as a partial 1031 exchange.
To learn more about when a 1031 exchange, click on the button below to download a free three page review of “Ten Reasons Why a 1013 Exchange Makes Sense.”
