Capital gain and 1031 exchanges are as intrinsically related as are the terms cause and effect. The amount of capital gain is the cause and the deferral of the gain in an Internal Revenue Code (IRC) Section 1031 tax deferred exchange is the effect. As the capital gain increases, the value of the deferred tax also increases. The American Taxpayer Relief Act of 2012 permanently increased the Federal long term capital gain rate for top income earners (Modified Adjusted Gross Income of $400,001 + for individuals and $450,001 + for married filing jointly) from 15 percent to 23.8 percent including the IRC Section 1411 3.8 percent Medicare Surtax. Consequently, high income taxpayers who plan to replace the disposed asset within 180 calendar days with a like-kind asset have the incentive with a 1031 exchange to indefinitely defer the capital gains tax on real and personal property held in a business or for investment. By deferring the gain, those otherwise paid out dollars are used towards the replacement property purchase, interest free.
Capital Gain
Capital gain is the investment profit realized when the capital asset is sold. Capital gain may be either short term or long term. Short term capital gain is when the asset is held for less than one year, while long term gain is when the property is held for one year and a day or more. The Federal short term capital gain tax rate is the taxpayer’s ordinary income rate which may be higher than the long term rate. The Federal long term rates are defined below. If the taxpayer income is below $36,500 filing individually or $72,500 filing jointly, the Federal long term capital gain rate is zero. One reason why the capital gain rate is lower than the taxpayer’s ordinary income tax rate is to encourage investment.
| Individual | Married | Capital Gains | Medicare Surtax | Aggregate Tax |
| $0 – $36,250 | $0 – $72,500 | 0% | 0% | 0% |
| $36,250 – $200,000 | $72,250 – $250,000 | 15% | 0% | 15% |
| $200,000 – $400,000 | $250,000 – $450,000 | 15% | 3.8% | 18.8% |
| $400,001 + | $450,001 + | 20% | 3.8% | 23.8% |
The realized gain is determined by subtracting the adjusted basis from the asset’s selling price and selling expenses.
- Original Purchase Price + Improvements – Depreciation Taken = Adjusted Basis
- Asset Sales Price – Adjusted Basis – Selling Expenses = Realized Gain
The recognized gain or tax is then determined by:
- Depreciation Taken x 25 percent
- Realized Gain – Depreciation Taken x Federal, State and County Capital Gain Tax Rate
1031 Exchange
IRC Section 1031 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.” No gain or loss shall be recognized implies the tax is deferred until the replacement property is sold. Property represents both real and personal property, while held suggests a season of time to allow the property to be used in a business or for investment. Examples of real property include:
- Vacation rental
- Land
- Single family rental
- Apartment
- Commercial building
- Cell tower
Examples of personal property include:
Time is not defined in the 1031 code but a one year hold is the suggested minimal hold time. 1031 exchanges can be initiated for property held for less than one year and should have facts that support the shorter hold such as an unsolicited offer that makes economic sense. Like-kind means any real property held in the United States for any real property held in the United States or international or international real property. Personal property must be exchanged for like-kind or like-class within the same asset class as defined in the Thirteen General Asset Codes or North American Industry Classification System (NAICS).
The capital gain rate increase directly impacts the potential tax deferral available in a 1031 exchange. If you have questions regarding a potential 1031 exchange, please contact our office or click on the button below and anticipate a response within 12 hours or less.
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