Most often associated with investment real estate, the 1031 tax exchange is an effective way to delay (but not forgive altogether) the payment of federal, state and local capital gains and recaptured depreciation tax for property that is held for the productive use in a trade or business or for investment upon sale. It’s important to understand the concept of the 1031 tax exchange and also certain rules that must be followed in order for the tax deferment to be allowed via IRS Regulations.
1031 Tax Exchange Intent
The IRS allows for capital gains tax to be deferred for property that is held for trade, business or for investment upon its sale, so long as it is replaced with property of like-kind. The motive of the IRS in allowing the 1031 tax exchange is that it is thought that if a person uses the proceeds from the sale of the property to purchase a like-kind property, there is no real economic gain or equity or mortgage boot, it is merely an exchange of property. Once the person sells the property in the future and does not use the proceeds of the sale to purchase a property of like-kind, the capital gains tax will be due on the sale of the current sale and on the tax that was previously deferred.
The Joint Committee on Taxation estimates the value of the 1031 tax exchange to be
1031 Tax Exchange Requirements
There are some things that should be noted when contemplating a 1031 tax exchange and the IRS website should be consulted for full detail, but here are some main points:
Property must be held for trade or business or for investment. Personal property such as aircraft, equipment, precious metals, vintage cars, livestock, artwork and collectibles are also eligible for 1031 tax exchange.
Property must be “like-kind.” More often than not, any real estate will be considered like-kind. Stocks, bonds, partnership interests, notes, inventory and primary residences are not eligible for a 1031 tax exchange.
Upon sale of the original property, a replacement property must within 45 days be identified and the appropriate party notified, and the final acquisition of the new property must be completed no later than 180 days following the sale of the original property.
All of the proceeds from the sale of the property must be used towards the purchase of the replacement property to defer 100 percent of the capital gain in a 1031 tax exchange. Any amounts from the sale not used for the purchase of the new property is fully taxable at the time of sale. Partial exchanges are possible but at a point of 50 to 60 percent property replaced, it may not make sense to initiate a 1031 tax exchange. See example below.
Here is a quick example to help understand the metrics of a 1031 tax exchange.
Real Property 1031 Tax Exchange Example
Pamela is moving from California to New York and decides that she is going to sell her California investment property because it will be too much trouble to maintain it from across country. As she is in the process of selling her property for $1,000,000, she locates another investment property located in New York, which she is interested in purchasing for $850,000. This puts Pamela in a perfect situation to benefit from a 1031 tax exchange. Because the new property is less than what she had sold her old property, she would be responsible for taxes immediately on the amount above the new property price. She would be able to defer $850,000 in taxes until she sold the new property and would immediately be responsible for taxes on the $150,000. On the flip side, had Pamela sold the old property for $850,000 and purchased the new property for $1,000,000, she could defer the taxable gain on the $850,000 sale price.
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