In a 1031 exchange, federal and state capital gains and recaptured depreciation taxes are deferred when real property held for use in a business or for investment is sold and replaced with like-kind real property. There are many rules to follow with one of those being that the exchange must be completed within 180 calendar days.
1031 Exchange
There are many reasons why a 1031 exchange makes sense. It could be that the taxpayer, who can be an individual, trust, partnership or corporation, uses the following in their business:
- farmland
- commercial building
- a vacation rental property
to be replaced with more efficient properties that can provide greater cash flow or depreciation to offset income. Perhaps the taxpayers have moved to be closer to their families and now want their investment properties to be close by to oversee. Land is sold and replaced with a property that provides a cash flow. Commercial properties are sold and replaced with properties in the path of progress to benefit from the anticipated appreciation in value.
The 1031 exchange provides the mechanism to easily replace assets with another without having to pay the immediate tax consequences. In effect, an interest free loan is the outcome for use towards acquiring the replacement property.
Stepped Up Basis Impact
When a taxpayer dies, their property can be given to their heirs. The property may initially go into an estate where taxes are imposed based on federal tax laws. The American Taxpayer Relief Act effective January 2, 2013 affected changes to estate taxes that should be reviewed with appropriate counsel. Where property is passed on to the heirs or beneficiaries, the receiving taxpayers take ownership of the property at comparable market prices. Comparable properties prices are determined by a market analysis of what other properties with similar characteristics have sold. The comparable market price represents the price or basis the heirs receive the property. Their tax basis is not the price their decedents paid for the property, rather the property value is stepped up to the date of their death.
The stepped up basis impact on 1031 exchanges is huge. If the property is sold soon after the property is received, there is no appreciation or depreciation. Consequently, there is no gain, tax due or need to initiate a 1031 exchange. If the property is held for a couple of years after the property passes to the heirs, then the capital gains tax needs to be determined. Given the current market as of the date of this article, there may a good chance the property has not appreciated to the point where a sizable tax is generated.
Determining the Recognized Gain or Capital Gains Tax
To determine the tax consequences, the first step is to take the comparable market price which represents the original price plus improvements less depreciation taken. This equals the adjusted basis. Next, the sales price for the property less the adjusted basis less the selling expenses, such as realtor commissions and title fees, equals the realized gain. Depending upon the taxpayer’s income bracket and state capital gains tax rate, the tax is determined by subtracting the depreciation taken (by the current taxpayer) from the realized gain and multiplying by 25 percent. This represents the recaptured depreciation if depreciation was taken on the current taxpayer’s tax return. The federal, state and possibly county capital gains taxes are applied to the remaining balance to determine the recognized gain or tax due.
Once the tax is determined, a decision can be made to whether initiate a 1031 exchange or pay the tax and avoid having to replace the property.
If you have received primarily real estate from a decedent and are considering selling the asset, seek the counsel of your CPA to understand the tax consequences.
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