“Does a 1031 exchange make sense?” is a common question investors and business owners ask themselves when selling property. The answer is that it depends on a number of facts including how long the asset has been held, what is the taxpayer’s adjusted gross income, is the taxpayer married or an individual, what is the recognized gain or tax due on the sale and finally, is the intent to replace the asset? If the responses are that a 1031 exchange does make sense, what are the tangible benefits?
Internal Revenue Code Section 1031
Section 1031 of the Internal Revenue 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.” Simply put, the 1031 exchange is a simple strategy to replace an asset with another and defer the tax obligation triggered when sold. The tax does not go away unless the beneficiary sells the asset soon after receiving from the deceased owner in what is known as stepped up basis.
In effect, the 1031 exchange is an indefinite interest free loan that is not due until the replacement property is sold or deferred again in another 1031 exchange. The 1031 exchange provides additional working capital that would otherwise be paid out to the US Treasury. There are many reasons why corporations and individuals deploy the 1031 exchange strategy.
Real and Personal Property
Property held in the productive use of a trade, business or for investment is eligible for 1031 consideration. Real estate, including land, single family residential, vacation properties, commercial, thirty year leases and water and mineral rights are prime examples of real property whose recognized gain can be deferred. Aircraft, artwork, livestock, gold and silver bullion, classic and special interest cars, memorabilia, collectibles, ships, railroad cars and locomotives, equipment, cars, trucks and busses are eligible.
1031 Tangible Benefits
Relocation – the taxpayer is relocating to another part of the country and wants their investment to be located close to them. Timber Real Estate Investment Trusts or the owners of an apartment building utilize 1031 exchanges to relocate their asset for either production efficiencies or to improve revenues.
Cash Flow – Land owners who do not rent their acreage to tenant farmers or hunters may want to exchange for real property that generates cash flow.
Depreciation – Property owners, who have owned their improved real estate or personal property for many years, may want to replace their property for like-kind property with greater efficiencies or longevity.
Diversification and Consolidation – 1031 exchanges allow the taxpayer to sell one and replace with multiples or sell many to acquire one replacement property.
Tax Consequence
The first step in every 1031 exchange is to visit with your CPA to determine the tax due upon sale. The tax due is one reason in addition to the benefits outlined above to initiate a 1031 exchange.
Original Purchase Price + Capital Improvements – Depreciation = Adjusted Basis
Sales Price – Adjusted Basis – Selling Expenses = Realized Gain
The first of three taxes is recaptured depreciation or 25 percent of depreciation taken or not.
Federal Capital Gain tax rate given the property is held for one year or more dependent upon the following chart.
Property held for less than one year is treated as ordinary income ranging from 10 percent to 39.6 percent. Collectibles and certain tangible personal property are taxed at 28 percent.
The 3.8 percent Medicare surtax applies to “net investment income” as defined in Internal Revenue Code Section 1411.
State Capital Gain tax rate is applied.
Some counties assess a capital gains tax as a potential fourth tax.
The total tax due can represent upwards of 40 percent of the sales price.
1031 Exchange Disadvantages
A Qualified Intermediary (QI) is required to facilitate the 1031 exchange. The QI is dependent upon the size and complexity. In the overall scope of the transaction the QI fee is minimal and ranges from $700 to low five figures for complex reverse exchanges. The QI role is to provide exchange agreements to support the taxpayer’s 1031 intent and hold the net equity from the sale for use towards the replacement property acquisition. The QI provides exchange advice how best to structure the transaction.
The taxpayer foregoes the use of the net equity from initial exchange other than for use towards the replacement property purchase. In a partial exchange, cash can be received from the transaction but is subject to tax.
The replacement property has a reduced basis lowering the annual cost recovery deductions that otherwise would be available given the replacement property was acquired without a 1031 exchange.
Should you or your CPA wish to discuss whether a 1031 exchange makes sense, click on the button below for a follow up within the next twelve hours or less.
