In 2012, Section 1031 exchange of the Internal Revenue Code will defer an estimated $3.2 billion in capital gains and recaptured depreciation taxes for individuals and corporations, according to the Joint Committee on Taxation. The tax deferral is estimated to be $3.7 billion and $4.1 billion in 2013 and 2014 respectively. What do these taxpayers have that you may not?
- Investment or a commercial realtor, CPA, real estate attorney, title officer or financial advisor familiar with a 1031 exchange.
- A clear understanding of the value of a 1031 exchange.
- Real and personal property held for productive use in a business or for investment.
What is the Impact of a 1031 Exchange?
Section 1031 exchange of the of the Internal Revenue Code states that no gain or loss is recognized when property held for productive use in a business or for investment is exchanged for property held for productive use in a business or for investment. Simply put, property, either real or personal, such as investment, rental and commercial property, land or aircraft, vintage cars or precious metals held in a business or for investment is eligible for a tax deferral on the gain triggered when sold, given like-kind property is replaced within 180 calendar days.
The tax deferral represents an indefinite, interest free loan until the replacement property is sold or stepped up to heirs upon death, in which case, depending upon the circumstance, the deferred tax may be eliminated. The 1031 exchange defers the federal and state capital gains and recaptured depreciation tax that can represent upwards of 40 percent of the sales price. Imagine being given an interest free loan on land with an original purchase price of $150,000 and $100,000 of improvements depreciated over ten years sold with eight percent selling expenses:
State | Tax | Estimated Tax | |||
Sales Price | 300,000 | 400,000 | 500,000 | 700,000 | |
Alabama | 5.00 | 16,109 | 34,509 | 52,909 | 89,709 |
California | 9.55 | 18,946 | 41,532 | 64,118 | 109,290 |
Florida | 0.00 | 12,991 | 26,791 | 40,591 | 68,191 |
Iowa | 8.98 | 18,591 | 40,653 | 62,714 | 106,837 |
Kansas | 6.45 | 17,013 | 36,747 | 56,481 | 95,949 |
Kentucky | 6.00 | 16,733 | 36,053 | 55,373 | 94,013 |
Montana | 6.90 | 17,294 | 37,442 | 57,590 | 97,886 |
Nebraska | 6.84 | 17,256 | 37,349 | 57,442 | 97,628 |
W. Virginia | 6.50 | 17,044 | 36,824 | 56,604 | 96,164 |
The tax deferral is even higher with collectibles, given the capital gains rate is 28 percent versus 15 percent for real property. Effective January 1, 2013, the federal capital gains rate is scheduled to increase to 20 percent with an additional 3.8 percent for taxpayers with income greater than $200,000.
What are the 1031 Rules?
There are many. A qualified intermediary is required who cannot be someone or firm you have worked with in the two year period prior to the exchange such as your lawyer, CPA or realtor. There are exceptions to what is known as disqualified persons. The titleholder who sells is the titleholder who buys. The replacement property value must be equal to or greater than the property sold. The exchange must be completed within 180 calendar days of the initial closing. Property must be formally identified to the Qualified Intermediary by the 45th calendar day post-closing. If selling or acquiring from a related party, there are special rules to follow. The taxpayer cannot pledge, borrow or receive a benefit from the proceeds while they are held in the exchange.
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