The taxes due on the capital gains and claimed depreciation upon the sale of an investment property can be quite substantial, often times to the point where any possible profit on the sale can be eliminated. Enter the 1031 tax exchange. Title 26, Section 1031 of the Internal Revenue Code states that, “no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment.” No gain or loss recognition ultimately means that no taxes are due upon the sale of the old property, or temporarily deferred which can be highly beneficial. The benefits of completing a 1031 tax exchange obviously lie within the tax benefit realm. Here are a couple of reasons to use a 1031 tax exchange.
Multiple 1031 Exchanges
“Swap ’til you drop” & never pay taxes: The 1031 tax exchange rule stipulates that upon the final sale replacement property, the property owner will at that time become responsible for the capital gains tax and depreciation claimed on all of the properties for which the tax was deferred. But if the property owner continues to exchange properties using a 1031 tax exchange, the taxpayer essentially continuously puts off the paying of those taxes. Upon the property owner’s ultimate death, the taxes could potentially become avoided altogether, depending on the then current estate laws.
Example: Martin completes a 1031 tax exchange, selling property A and acquiring property B. Because he completes a 1031 tax exchange, he defers paying taxes on A at the time of the sale. Five years later, Martin sells property B and acquires property C. Martin has now successfully deferred payment of taxes for both A and B. This cycle can continue endlessly.
Reinvest Tax Savings
In completing a 1031 tax exchange, a property owner is allowed to use all of the net proceeds from the property sale towards the purchase of the replacement property. The IRS is essentially letting the property owner borrow that tax money free of charge.
Capital Gains and Depreciation Tax
Save on both capital gains tax and depreciation. A 1031 tax exchange is an effective way to defer the capital gains tax and tax on depreciation that would typically be associated with the sale of an investment property. This is best described with an example.
Example: Martin bought a residential investment property 5 years ago for $200,000. For simplification, let’s say 100% of the value is depreciable. According to IRS rules, residential investment properties can be depreciated over a 27.5 year span. Martin decides to sell the property for $300,000 and replace it with a new investment property using a 1031 tax exchange. Over the five years, Martin realized a $100,000 capital gain. During that time frame, he also depreciated the property $7,273 per year ($36,365 total for five years). If he were to complete the transaction without a 1031 tax exchange, Martin would be responsible for taxes on the $100,000 capital gain as well as $36,365 in depreciation claimed, but because he completes a 1031 exchange, Martin is able to defer paying taxes on $136,365 and is instead able to put those proceeds towards equity in the purchase of a replacement property.
Cash Flow
Use a 1031 tax exchange to replace property such as land for a rental property to generate cash flow. Timberland REITs use 1031 exchanges to sell unproductive tracts of timber for tracts that correlate with their investment strategies such as a species of softwood or hardwood along with proximity to their mills.
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