Deploying a capital gains tax deferral strategy merits additional attention given the pending federal changes effective January 1, 2013. Taxes on ordinary income will increase from 35 percent to 43.4 percent for earners in the highest bracket. The long-term capital gain rate will increase from 15 percent to 23.8 percent including the new 3.8 percent “health care tax” on interest, dividends and other passive income earned by individuals with income more than $200,000 per year, or $250,000 for married taxpayers. The estate and gift tax will also change. The current estate and gift tax exclusion is $5 million with any excess subject to a federal estate tax of 35 percent. Effective in 2013, the exclusion returns to $1 million with the maximum estate and gift tax increasing to 55 percent.
Capital Gains
A capital asset is any real, tangible and intangible personal property held as an investment or for use in business or trade for a year or more. Tangible assets may offset income in the form of depreciation given a useful life of one year or more. Examples of capital assets are improvements to land, such as a commercial or investment property, aircraft, livestock and equipment.
When capital assets are sold, federal and state capital gains and recaptured depreciation taxes are triggered that can result in taxes of 40 percent or more. Capital gains is the net gain earned after depreciation and selling expenses given the capital asset is sold at a higher price than the original purchase price. A depreciated asset sold for a loss will trigger a 25 percent depreciation recapture tax for depreciation taken or not over the years.
1031 Tax Deferred Exchange
A 1031 exchange is a recognized capital gains tax deferral strategy. If the taxpayer sells and replaces with like-kind property, the capital gains tax is deferred until the replacement property is sold. There is no limit to the number of 1031 exchanges that can be initiated. Capital gains taxes may be eliminated upon death resulting in a stepped up basis to the taxpayer’s beneficiaries. Converting a rental property to a primary residence allows for the Section 121 exclusion of $250,000 for taxpayers filing as individuals and $500,000 for taxpayers filing jointly to absorb the deferred capital gains, excluding the depreciation and nonqualified use or time the replacement property was held as a rental.
How a 1031 Exchange Works
The taxpayer owns either real or personal property, held in a trade, business or for investment. When the property is sold and replaced with like-kind property of equal or greater value within 180 calendar days of each other and does not touch the exchange proceeds, then the capital gains triggered is deferred indefinitely. A Qualified Intermediary is required to prepare the exchange documents supporting the taxpayer’s intent and hold the net sales funds or exchange proceeds in an escrow account created under the taxpayer’s identification number. Foreign taxpayers subject to federal income taxes can also initiate 1031 exchanges without having to pay the ten percent withholding required by the Foreign Investment in Real Property Tax Act of 1980 (FIRPTA).
Property can be any real property exchanged for any real property given the location is within the United States. Capital gains on foreign property can also be deferred given the location is international. The exchange of personal property is far more restrictive. Personal property replaced must be like-kind or like-class. Furniture must be replaced with furniture, aircraft for aircraft, ship for ship, artwork for artwork, precious metals for precious metals, medical equipment for medical equipment, cars for cars and trucks for trucks.
More importantly, the 1031 exchange must be initiated prior to the transaction closing. Once the taxpayer receives access to the net proceeds, the exchange is over. Call our office to learn more or request a complimentary consultation by clicking on the button below.
