Upon the sale of real or personal property held in a business or for investment, the seller is subject to a hefty capital gains and recaptured depreciation tax which would be due upon the sale on the realized gain over the original purchase price. Though capital gains tax is excludable up to $250,000 or $500,000 for property owners selling their primary residence once every two years per Section 121, for an investor selling real or personal property, it is possible to defer the tax with a 1031 like kind exchange. A 1031 like kind exchange is a fairly complex transaction that can be a great benefit to the property owner if done correctly.
Exchange Timelines
A like kind exchange has very strict timing deadlines that must be followed in order to qualify for the tax deferral. Within 45 days of the sale of the original property, the taxpayer must identify a replacement property and within 180 days of the sale of the original (relinquished) property, the taxpayer must have completed the transaction and be in ownership of the new (replacement) property. The idea behind these deadlines is to not allow taxpayers to enter into a like kind exchange on a property they sold many years ago.
Proper Intent
To qualify for a like kind exchange, both the relinquished property and the replacement property must be held and must have been held for trade or business or as an investment. As mentioned above, this means a taxpayer cannot enter into a like kind exchange with their primary residence. Another important note is that the properties must be of like-kind, hence the name like-kind exchange. The most common type of property taxpayers exchange is real estate, and generally speaking, all real estate will be considered like-kind to each other. Peronal property must be exchanged for personal property in the same asset class or North American Industry Classification System code.
Debt and Equity
The taxpayer that is entering into a 1031 like kind exchange is allowed to defer up to 100 percent of the capital gains that is reinvested in a like-kind property. The IRS’s reasoning behind the 1031 deferral is that given the taxpayer has not received cash or reduction in debt by replacing with replacement property equal to or greater than the relinquished property there is no tax due. Rather than paying the capital gains tax, the net equity from the relinquished property sale and retired debt is replaced in the replacement property.
Here’s an example to understand the mechanics of a like kind exchange.
Paul has decided to enter into a 1031 like kind exchange on the property he originally purchased for $500,000. He has found a buyer for the property, who will be paying $650,000, resulting in an estimated capital gain of $150,000. Paul has also found a replacement property at a cost of $800,000. Because the entire $150,000 of the capital gain is being reinvested in the replacement property, Paul would be able to defer 100 percent of the capital gains tax that would typically be due on the sale. If, however, the replacement property had a cost of $450,000, Paul would be responsible for the tax due on the $200,000 capital gain because he would not be reinvesting all the proceeds.
1031 exchanges have many, many sets of rules that apply and come in either a forward or reverse strategies. To learn “Ten Reasons Why a 1031 Exchange Makes Sense,” download a three page eGuide by clicking here.
