Taxpayers considering initiating a 1031 exchange should ask themselves, “Why?” Has their CPA or tax attorney suggested they should? Has their Realtor recommended a Qualified Intermediary to call? Entering into the domain of a tax deferral requires an inquisitive disposition; is it subject to new terminology and rules, plenty of IRS rules. A 1031 exchange is not for the faint of heart; rather, the determined and those who persevere. There is help, starting with your CPA.
Reason Number One – Tax Deferral
When real or personal property is sold, federal and state capital gain taxes are triggered. If the property sold for more than the original purchase price, chances are the difference will be subject to a tax. If the property is deemed non-commercial, the improvements are subject to depreciation over 27.5 years, representing a 25 percent depreciation recapture tax whether or not the depreciation was taken. The total tax can represent nearly half of the sales price. If the taxpayer’s intent is to replace with property of equal to or greater value, the taxes can be deferred.
On a $100,000 sale, rather than paying $40,000 in taxes, you could acquire one or multiple replacement properties totaling at least $100,000. The deferred tax represents an indefinite, interest free loan or additional working capital. Would you pay the tax or defer the gain?
If the property sold was considered a collectible, such as artwork, vintage and classis car or silver and gold bullion, the federal capital gain rate is 28 percent. The federal capital gain tax on the sale of a $500,000 classic car bought for $100,000 is $112,000 before adding the state capital gain tax.
Seek the input of your CPA or tax attorney to determine the tax consequence of the sale.
Reason Number Two – Relocation
Jack and Martha are in their sixties living in the upper Midwest. They would like to retire in a vacation community within driving distance of their grown children. One alternative is to sell a farm, land or investment property and replace with a vacation property in a 1031 exchange. Then after holding as a rental property for two years, convert it to their primary residence.
The business owner wants to relocate their fast food franchise to an area in the path of progress for more foot traffic. The timber company wants to sell a tract of Loblolly pine trees and replace with a tract of Southern Live Oak. An apartment owner in New Jersey wants to sell and replace with another apartment in New York. An excavating equipment company needs to replace their aging equipment with the same class or group of equipment.
A 1031 exchange enables the taxpayer to replace the asset.
Reason Number Three – Improvements
Ted owns a four bedroom condominium and wants to replace with a three bedroom condominium on the top floor, but he wants to make improvements including updating the bathrooms and new furniture, appliances and flooring. In an improvement exchange, the exchange proceeds can be used to acquire and fund the improvements, including the personal property.
Cullen owns land that he wants to sell to replace with a log cabin in the Appalachian Mountains north of Atlanta. The proceeds from the land sale can purchase the new lot and fund the building of the cabin.
Helen is selling a cattle ranch in Oklahoma to replace with a ranch in Texas that requires a new barn, feedlot, driveway, irrigation and fencing for her cattle.
Property sold can be replaced with property with improvements funded by a 1031 exchange.
In addition to the three reasons provided there are many others, including appreciation, depreciation, diversification, consolidation and cash flow.
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