The benefits of a 1031 exchange have been well-documented by CPAs and financial advisors as a wealth building strategy for individuals, trusts, partnerships and corporations — both United States residents and non-resident foreigners. The core of the strategy is the deferred federal, state and recaptured depreciation taxes, enabling the taxpayer to cash in on, an indefinite interest free loan given like-kind replacement property of equal or greater value is acquired and strict 1031 exchange rules are followed.
Recognized Gain
When property held for productive use in a trade, business or investment is sold, federal and state capital gains and recaptured depreciation taxes are triggered on the difference between the original selling price, plus improvements and less depreciation. In trade terms, this is known as adjusted basis and the sales price less the adjusted basis and selling expenses such as sales commissions and title fees.
- The current long term capital gains rate is 15 percent for taxpayers in the 25 percent and up tax bracket. The rate is scheduled to increase to 20 percent effective January 1, 2013 and an additional 3.8 percent for taxpayers earning above $200,000.
- States taxes range from 0 to 10.75 percent.
- Recaptured depreciation is 25 percent of depreciation on the value of property improvements.
For example, Jack and Emily own a vacation rental property they purchased in 1995 for $80,000 and have entered into a sales contract to sell the investment property for $330,000. The reason they are selling is that they want find another investment property closer to their grown children that they can later make their primary residence. They have made $50,000 of improvements including a new roof, air conditioning and remodeled kitchen and bathrooms.
The recognized gain or tax due for Jack and Emily, who are residents of New Jersey is an estimated $57,069.
- Recaptured depreciation is $8,000
- Federal capital gains is $26,580
- New Jersey state capital gains tax is $22,489
1031 Exchange
Section 1031 of the Internal Revenue Code states that no gain or loss is recognized when property held for the productive use in a trade, business or investment is exchanged for property held for productive use in a trade, business or investment. No gain or loss means that the recognized gain or loss on the sale of property is due when property of equal or greater value is acquired. Partial deferrals are possible, yet there is a point when a 1031 exchange doesn’t make sense.
By initiating a 1031 exchange, Jack and Emily defer the $57,069 tax by acquiring real property equal to or greater than the sales price less the selling expenses of $22,800, made up of sales commission and closing expenses, or $307,200. The tax obligation does not go away but is deferred until the replacement property is sold. The risk is that federal and state taxes will be higher at the time of sale. Even if they are, there is no limit to the number of 1031 exchanges.
Tax Consequences of Selling a Primary Residence Converted from a Rental Property
After a couple of years as a rental, the property can be converted to a primary residence such that after holding the property five years, the Section 121 $500,000 exclusion for married couples or $250,000 for individuals selling a primary residence effectively eliminates the $49,069 tax. The exclusion does not apply to the recaptured depreciation. For more information, read the short article below.
1031 Eligible Property
Any real property held in a trade, business or for investment is eligible for a 1031 tax deferral given the replacement property is also located in the United States. Real property held internationally is eligible for real property held overseas. Land can be exchanged for a single family rental, commercial or water, oil and gas rights, given the state where the property is located also recognizes the property as real. Aircraft, artwork, precious metals, equipment, musical instruments, livestock and vintage cars are eligible for a 1031 exchange given the replacement property is like-kind or like-class.
1031 Exchange Rules
There are many 1031 exchange rules including:
- Same Taxpayer Requirement
- Exchange Requirement
- Related Party
- Disqualified Person
- Reporting a 1031 Exchange
To receive a complimentary eBook on “Ten Reasons When a 1031 Exchange Makes Sense,” click on the button below. You will receive the eBook within seconds.
