A 1031 exchange enables taxpayers to defer federal and state capital gain and depreciation recapture taxes when selling and replacing property held in a business or for investment. The tax deferral represents an indefinite, interest free loan or additional working capital for use towards the replacement property acquisition. The tax does not go away but is due once the replacement property is sold unless another 1031 exchange is initiated.
1031 exchange explained
What to Know About a 1031 Exchange
“What is a 1031 Exchange?” is a question I asked in June, 2003. Nearly twelve years later and having accommodated over 680 simple and complex, real and personal property, US and foreign based 1031 exchanges, listening and responding to thousands of 1031 related questions, the answer is “It depends upon the transaction.” Every 1031 exchange is different; however, each share the same goal to defer federal and state capital gain and depreciation recapture taxes that can represent upwards of 40 percent of the sale price. Each 1031 exchange must follow strict rules as defined in Internal Revenue Code Section 1031. A 1031 exchange is either a forward or reverse, meaning either the old or relinquished property is closed before the replacement property closing or the replacement property is closed before the relinquished property closing.
Four Initial Steps in a 1031 Exchange
When taxpayers are considering a 1031 exchange, there are four initial suggested steps. Often times, the question is asked when is it too late for a 1031 exchange. The answer is when the net proceeds have been received from the sale–either directly or indirectly–such as deposited into your account. If the buyer is willing, you can potentially unwind the transaction, including not recording or re-recording the title to your name and returning the funds to the buyer. If a lender is involved, then the probability of rescinding the closing is quite low.
Four Reasons Why a 1031 Exchange Fails
A 1031 exchange allows the federal and state capital gain and depreciation recapture taxes to be deferred when selling and replacing with property held in the productive use of a business or for investment. There are many rules that must be followed, with one of those being to use a qualified intermediary except in a two party exchange when the exchangor and the buyer want to purchase each other’s property. The qualified intermediary is responsible for generating exchange agreements in accordance with the Internal Revenue Code Section 1031 requirements and holding the exchange funds or net equity from the sale for use by the exchangor to acquire the replacement property.
1031 Exchange Advantages
There are many advantages and reasons for taxpayers to initiate a 1031 exchange when selling real and personal property productively held in a trade, business or for investment. The primary advantage is the deferral of federal and state capital gain and depreciation recapture taxes that can represent 40 percent of the relinquished or old property sales price. The deferral represents an indefinite interest free loan that is used as additional working capital to acquire the replacement property. The tax obligation does not go away, but rather is postponed until the replacement property is sold. The taxpayer can initiate any number of 1031 exchanges to continually defer the tax until death.
1031 Exchange Eliminated in Tax Reform Draft
Yesterday, elimination of Internal Revenue Code Section 1031 exchange was proposed by House Ways and Means Committee Chairman Dave Camp as a component of a nearly 1,000 page Discussion Draft for Comprehensive Tax Reform. If approved, the extensive changes would constitute a major overhaul of the complex U.S. tax system. Though the draft has not been proposed as a bill, it is destined for tax reform discussion most likely to be undertaken by Congress, possibly in 2015. Former Senator Max Baucus introduced a tax reform proposal last year that also includes the repeal of the 1031 exchange. Needless to say, the 1031 exchange regulation will be part of the intense discussion.