In the United States, upon the sale of property, a taxpayer generally must pay a capital gains tax on the realized gain, which in some cases can be in upwards of 40 percent of the realized gain. The realized gain is determined by the difference between the original purchase price of the property, plus capital improvements less depreciation and the selling price less the selling expenses. With such a high potential capital gains tax, in can often bring in to question whether the sale of the property will end up being profitable or not.
Capital Gain
Capital gain is the net outcome following the sale of the asset. Depending upon whether the asset was held for less than or greater than a year affects the tax or recognized gain on the net outcome or realized gain. A capital asset held and sold in less than one year is treated as ordinary income. A hold time in excess of one year is taxed at long term capital gain tax rates that range depending upon adjusted gross income from 0 to 28 percent depending on the type of asset.
1031 Exchange
Section 1031 of the Internal Revenue Code by the IRS allows in certain situations for an investor to delay the capital gains tax that would be due upon the sale to a point in the future when that property is subsequently sold, which is known as a 1031 exchange. The taxpayer is allowed to defer up to 100 percent of the capital gains tax that would typically be due as long as the proceeds from the sale of the property are re-invested in like kind property. Here are some of the guidelines a taxpayer must remember when completing a 1031 exchange to defer the capital gains tax.
Like Kind
In order to defer the capital gains tax, the taxpayer must have held the property that is being sold and must intend to hold the property that it is replacing, known as the replacement property, for trade or business or for investment. A 1031 exchange cannot be completed on personal residences. The property being exchanged must be of like-kind to each other as well. For all intensive purposes, real estate (which is the most common kind of property exchanged via the 1031 exchange), will always be of like-kind to one another. Personal property including artwork, gold and silver bullion, numismatic coins, equipment, barges, locomotives, railroad cars, livestock and business aircraft are eligible for tax deferral treatment.
Timeframes
Timing is another important factor in ensuring the capital gains tax is eligible to be deferred. The taxpayer should identify that he/she intends to complete a 1031 exchange to defer the capital gains tax before the sale of the initial property. All parties are informed at closing of the taxpayer’s intention to initiate a 1031 exchange. Upon the aforementioned sale, the taxpayer must identify a replacement property within 45 days and must complete the transaction for the replacement property within 180 days.
Here is an example to help understand the concept of deferring the capital gains tax.
Lori is completing a 1031 exchange to defer the capital gains tax on the sale of her investment property. She is selling her property for $300,000 that was originally purchased for $250,000, so her realized gain is $50,000. The replacement property is being purchased for $400,000. Because the replacement property is being purchased for more than the sales price of the old property, Lori would be eligible to defer 100% of the capital gains tax until a point in the future when the replacement property is sold.
In the example, Lori could continue to defer any capital gains tax by again completing a 1031 exchange upon the sale of the replacement property. She could, if she played her cards correctly, continue to defer the capital gains tax forever.
Now let’s say Lori is purchasing the replacement property instead for $225,000. Lori has realized a gain from the sale of the old property of $50,000, but now she wouldn’t be re-investing 100% of the sale proceeds into the replacement property because it actually costs less. As a result, Lori would be immediately be responsible for the tax on the capital gain on the $75,000 that is not re-invested in the replacement property.
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