For many first time sellers of investment real estate, personal property or equipment held in a business, understanding a 1031 exchange can be a bit of a challenge. Each 1031 exchange is different and dependent upon the characteristics of the taxpayer and transaction. The Internal Revenue Code Section 1031 has many rules and restrictions that for the novice investor and qualified intermediary can be problematic if not facilitated correctly.
1031 Tax Deferral
When an asset such as land, single family residential investment property, condominium or business aircraft, cell tower, TV or radio station, Subway franchise, vintage car, gold and silver bullion, collectibles, artwork, livestock or mineral rights is sold, a tax known as recognized gain is triggered. The tax is the sum of the federal and state capital gains and recaptured depreciation tax (if asset is depreciated). The recognized gain can account for up to 40 percent of the sales price. The tax is due the year following the sale. The federal capital gains tax changed effective January 1, 2013. Capital gains taxes went from 0 to 23.8 percent for taxpayers with the highest adjusted gross income to zero with the lowest incomes. Collectibles are taxed at a 28 percent.
A 1031 exchange allows the taxpayer to defer the gain or paying the tax until the replacement property is sold. That means the taxpayer receives an indefinite interest free loan, or, on a $100,000 sale, a $40,000 loan or additional working capital by engaging a qualified intermediary to accommodate the exchange. A 1031 exchange is a huge benefit and used routinely by investors and corporations.
The alternative to the 1031 exchange is to pay the tax or possibly a deferred sales trust. There are times when an exchange does not make sense or is not possible under the transaction circumstances. Attention must be given to whether a related party is involved, how the property is titled and the duration property is held. Partnership interests, primary residence, inventory, indebtedness and stocks and securities are not eligible for the 1031 tax deferral.
Initial 1031 Exchange Steps
Talk with your CPA to determine the tax consequences of the sale. What is the tax? Is it your intent to replace the net selling price in the replacement property? One of the 1031 exchange rules is that the replacement property must be equal to or greater than the net selling price of the old property. You can initiate a partial exchange, but when only 50 to 60 percent of the sales price is replaced; the tax due on the remaining 50 to 40 percent will be the same or near what would be paid if no exchange was initiated.
Next, engage a qualified intermediary and be prepared to provide an overview of the transaction. Search on the Internet or ask your Realtor, CPA or real estate attorney for a referral. Ask specific questions to vet the accommodator. Not sure what to ask? Then download for free a brief one page eGuide to four questions that the most experienced investors ask. Don’t be focused on price alone. Fulfilling IRS requirements is not the same as going to Walmart. Not all accommodators think and act alike.
The Purchase and Sale Agreement (PSA) can be signed before initiating the 1031 exchange. Many state Realtor Association PSAs have the 1031 exchange language embedded. If not, I suggest asking your Realtor or Broker to add the appropriate assignment language.
To learn “Ten Reasons Why a 1031 Exchange Makes Sense,” download a free three page eGuide by clicking on the button below explaining circumstances when a 1031 tax deferred exchange is in your interest. It is far better to ask before the closing, “What is a 1031 exchange?” than to learn after, when it is too late.
