The forerunner of the modern day 1031 exchange has traces to when goods and services first were traded. When cowboys traded horses or bulls and the one horse or bull was considered a better value than the one received, a weapon, food or cash was received to settle the difference, often placed in the cowboy’s boot for safekeeping. In today’s 1031 exchange, when the exchangor receives a benefit such as cash at closing or has a smaller mortgage than before, this is known as equity or mortgage boot. In 1921, Congress enacted the National Revenue Act that included the modern day 1031 exchange. The 1031 exchange component was based upon the fact that the economic position of the taxpayer did not change from one transaction to the next. The taxpayer has not received a benefit either in cash or reduction in mortgage, rather an old property has been replaced with another property. If a benefit was received, it is taxable.
Section 1031 of the Internal Revenue Code
The 1031 code 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.”
When capital assets are sold, such as real and personal property, federal and state capital gains and recaptured depreciation taxes are triggered that can represent upwards of 40 percent of the sales price. Currently, the federal long term capital gains tax for married and individuals in the 10 and 15 percent income brackets is zero. For those in the 25 percent and up, the long term rate is 15 percent for real property and 28 percent for personal property. Long term rates are when the asset is held for at least a year and a day. Assets held for a year or less are taxed at the ordinary income rate.
Tax Law Changes
Long term capital gains rates are scheduled to change effective January 1, 2013, increasing the rate from 15 percent to 20 percent. For individuals and marrieds with a modified adjusted gross income exceeding $200K and $250K respectively, an additional 3.8 percent Medicare Contribution tax is added.
A 25 percent depreciation recapture tax is imposed on depreciation of the asset whether or not it was taken. For those businesses that acquired and are selling aircraft and equipment, the 100 and 50 percent bonus depreciation allowed in 2011 and 2012 will result in a large recapture tax.
In a 1031 exchange, the gain or loss is not recognized. The tax is deferred indefinitely or until the replacement property is sold, at which time the taxpayer can enter into another 1031 exchange. Beneficiaries receiving property in a will receive a stepped up basis, meaning that their basis is the comparable value at the time the asset was received, not when it was originally acquired.
The estate tax will increase from 35 percent to 55 percent and lifetime exemption is reduced from $5 million to $1 million.
1031 Exchange Economic Fact Pattern
Given the taxpayer does not receive cash or a reduced mortgage in the replacement property, the taxpayer’s economic position does not change. The net equity from the relinquished property sale has been reinvested into the replacement property and if a mortgage is retired at the relinquished property closing, it has been replaced with equal or additional debt in the replacement property. The taxpayer can always add cash to offset debt, but additional debt does not offset cash.
For example, a taxpayer sells land for a price of $400,000 with $100,000 of debt, replacing with an investment property such as oil and gas royalty interests, triple net lease commercial property or a 20 unit apartment complex selling for $400,000. The $22,500 federal capital gains tax is deferred when the net equity of $250,000 ($400,000 less $100,000 debt less $50,000 selling expenses) and debt of $100,000 is placed in the replacement property. The taxpayer could offset the $100,000 debt with additional cash or have a loan of $100,000.
By deferring the federal capital gain tax, the marginal use of the dollar is maximized. Those taxable dollars that otherwise would have been paid to the IRS represent an interest free loan. Given appreciation and cash flow, the rate of return is higher than the alternative if taxes are paid. A 1031 exchange is contingent upon the taxpayer’s intent to replace the old property.
After running the numbers with your CPA to determine the tax due, call our office for a complimentary consultation of how a 1031 exchange works for your transaction. Download a free eBook on “Ten Reasons a 1031 Exchange Makes Sense.”
