A 1031 exchange enables a taxpayer, both United States resident and non-resident foreigner, to defer capital gains and recaptured depreciation taxes when exchanging real and personal held for productive use in a trade, business or for investment property for like-kind real and personal property. The tax deferral can represent upwards of 40 percent of the property’s sale price.
What makes this different from a typical sale is:
- A Qualified Intermediary (QI) is engaged to create documents in accordance with Internal Revenue Code regulations supporting taxpayer’s intent to enter a 1031 exchange
- 1031 proceeds or net equity from sale are held by the QI in an escrow account for the benefit of the taxpayer for use towards the acquisition of replacement property
1031 Exchange Example
For example, an individual in the 25 percent and up tax bracket owns a parcel of land purchased for $50,000 and enters into a contract to sell for $500,000. The estimated federal and state capital gains tax due given the individual is a resident of California is $96,973. The taxpayer can either pay the federal and state capital gains tax or defer the tax and acquire any real property in the United States. By affecting a 1031 exchange, the taxpayer receives an interest free loan until the replacement property is sold, given real property of equal or greater value is acquired within 180 calendar days of the old property closing.
Three Benefits of a 1031 Exchange
1.Interest Free Loan
While the tax deferral is clearly one of the three benefits, let’s take a closer look at the saving potential. Rounding the tax deferral up to $100,000, at a six percent interest rate, the interest saved by not borrowing from a bank over ten years is approximately $75,825. Add to this the potential cash flow from the replacement property such as a vacation, farm lease, commercial or single tenant, or triple net lease property and the rate of return grows.
2. Liquidity
The ability to sell one property and replace with another enables the investor to change investments for a variety of reasons such as the investment is not appreciating as quickly as anticipated, the expenses are higher than previously estimated, or rather than having multiple properties, the taxpayer wants to consolidate to improve operating efficiencies. The 1031 exchange allows the investor to change their assets without paying the immediate tax consequences.
3. Estate Planning
Currently property passed on to the taxpayer’s heirs at death, receives a stepped up basis. In another words, if Jack purchased land at $50,000 and upon his death the property is given his beneficiary at a current value of $500,000, his beneficiary could sell it and not pay capital gains tax on the $450,000 given Jack’s estate is less than $5 million, under current federal estate taxes. Effective January 1, 2012, the estate tax was indexed for inflation from $5 million to $5.12 million. For an overview of 2011 and 2012 estate tax and gift tax laws see this article.
Are you or your company selling capital assets or investment property with the intent of replacing with a similar asset? If so, be sure to consider the benefits of a 1031 exchange. Learn more with a complimentary eBook on “Ten Reasons a 1031 Exchange Makes Sense,” by clicking on the button below.
