capital gains

Capital Gains Tax Deferral for the Investor and Dealer

Posted on | by Tom Gustafson | Leave a Comment on Capital Gains Tax Deferral for the Investor and Dealer

Given today’s real estate market where the lure to fix and flip is a part of mainstream reality TV, a question often in the mix is whether a 1031 exchange will defer the capital gains taxes? With the newly renovated property, the next step is to either hold or resell. If the property is resold within a year of the purchase, the short term federal and state capital gains taxes can eliminate upwards of 40 percent of the gross profit. Can a 1031 exchange defer these taxes is now a question the investor or dealer must understand.

Intent and Facts

The Internal Revenue Code Section 1.1031 allows taxpayers to defer the gain or loss when property held in a trade, business or investment is exchanged for like-kind property held in a trade, business or investment. The proper intent to qualify for a 1031 exchange is that the property is held in a business or investment, unlike inventory held on the shelf at the auto parts store for profit or resale. Facts supporting proper intent include:

  • how long the property was held
  • whether or not it was rented
  • how was it itemized on the taxpayer’s federal tax return
  • amount of personal use

The shorter the hold, the more substantial the facts will need to be. The IRC does not specify a hold time, but the Internal Revenue Service has stated in writing that two years is sufficient.

Investor vs. Dealer

Enter another set of facts to understand: whether the taxpayer is an investor or a dealer. Before rationalizing the taxpayer is always an investor, it is important to understand how the courts are determining this outcome. An investor with the intent to defer gain in a 1031 exchange will hold the property to allow it to season as an investment, including renting the property at fair market rent. Personal use is limited to fourteen overnights per year. To be fully compliant with Revenue Procedure 2008-16, the property will be held for two years and in each of those years, the property will be rented fourteen overnights. The replacement property will also be held for two years and in each of those years, the property is rented out a minimum of fourteen overnights per year at fair market rent.

A dealer or the taxpayer who owns multiple properties can fix and flip, along with 1031 exchanges, given the two are accounted for separately. The court considers the following facts as provided by Klarkowski v. C.I.R., T.C. Memo. 1965-328:

  1. The purpose for which the property was initially acquired
  2. The purpose for which the property was subsequently held
  3. The extent to which improvements, if any, were made to the property by the taxpayer
  4. The frequency ,number and continuity of sales by the taxpayer
  5. The extent and nature of the transactions involved
  6. The ordinary business of the taxpayer
  7. The extent of advertising, promotion or other active efforts used in soliciting buyers for the sale of the property
  8. The listing of the property with brokers
  9. The purpose for which the property was held at the time of sale

The hard right decision, in the view of this qualified intermediary, is to pay the tax rather than pushing the envelope of a rationalized 1031 exchange. The surprise of an IRS audit is best offset with facts that support the proper intent.

Related articles of interest:

Tax Implications of Unwinding a 1031 Exchange

Posted on | by Tom Gustafson | Leave a Comment on Tax Implications of Unwinding a 1031 Exchange

Let’s face it. Times have changed. The tumultuous real estate market, renovations over budget, difficult tenants combined with the challenging job environment have resulted in questions about how to unwind a 1031 exchange. Imagine ten years ago, we survived the Y2K scare and were approaching the tech market bubble burst. Real estate appreciation was gaining traction. Washington was promoting regulations to help those interested in securing a home. Ten years is not a lot of time when you are young. But when you have experienced the depths of job loss, foreclosure and declining retirement portfolio your perspective changes questioning why not sell the rental property and cash out.

Three Reasons Why Unwinding a 1031 Exchange Makes Sense Before 2013

Every market is cyclical, which helps cleanse inefficiencies and to adopt new strategies. Adjusting to change is a maturing process requiring us to take note of the whole and the individual pieces. Three reasons why unwinding a 1031 exchange makes sense includes:

  • Historically low federal capital gains rate of 15% will sunset on December 31, 2012 to 20%. In 2013, federal capital gains will increase 3.8% Medicare tax for those earning over $200,000.
  • If in the ten or fifteen percent income tax bracket, your long term federal capital gains tax rate may be even lower than 15%.
  • Divorce and changing partnership interests: it may make sense to consider cashing out the partner and continue the tax deferral in another 1031 exchange if you want to continue holding real property.

Unwinding a 1031 Exchange

The first place to start is talking with your accountant to understand the tax consequences. If you are selling a replacement property purchased in a prior exchange, is you will have two sets of taxes, one due on the replacement property and a second set due on the original property sold. Questions to consider include:

  • What is your current federal income tax bracket?
  • Were the investment properties itemized on Schedule E?
  • Was depreciation taken on Schedule E of your tax return?

Your accountant will look to determine the adjusted basis of each property to determine the estimated recognized gain or tax due. The tax bill may not be as bad as you think. But not understanding the tax implication could also be quite risky.

If you would like to discuss the tax implications of unwinding your 1031 exchange, please contact us at office number 800-227-1031 or ask a question with the links above.

Three Easy Steps to Quantifying Capital Gains Tax

Posted on | by Tom Gustafson | Leave a Comment on Three Easy Steps to Quantifying Capital Gains Tax

1031 Replacement PropertyTax-Free Exchanges make sense when federal and or state capital gains taxes and recaptured depreciation exist.  Are they really tax free?  No, the taxes are simply delayed or postponed until the replacement property sells.  Another 1031 exchange can be initiated as many times as desired continuing to defer the capital gains tax.

Three Easy Steps to Determine Capital Gains

Adjusted Basis is determined by

Original Purchase Price

Plus Improvements

Less Depreciation

Realized Gain is determined by

Sales Price

Less Adjusted Basis

Less Selling Expenses

Taxes Due are determined by

Recaptured Depreciation:  Multiply the depreciation taken by 25%.

Federal Capital Gains:  Subtract the depreciation taken from the realized gain.  Then multiply the remainder by the capital gain rate for short term rate or ordinary income rate if asset is held for less than one year and a day.  If longer multiply the remainder by the long term rate or currently 15% as of November, 2010.

State Capital Gains:  In Indiana, the state capital gains rate is applied to the entire realized gain.  Each state may determine their gains differently.

Add the three numbers together and the total represents what is deferred in a 1031 exchange.  Some states do not impose a state capital gains tax, consequently, add the two numbers to determine the tax that can be deferred.

What is Capital Gains

Capitals gains is the tax on the investment income or profit earned from holding or owning real or personal property.  Capital gain is triggered when the asset is sold resulting in a tax obligation if as determined above a capital gain exists.  Recaptured depreciation is determined by taking the total amount of depreciation itemized on federal income tax returns multiplied by 25%.

To learn more exchange tips, download a free guide that also includes

  • FOUR Exchange Rules
  • What is and is not eligible for a 1031 exchange
  • Identification Rules

Tax Implications of Unwinding a 1031 Exchange

Posted on | by Tom Gustafson | Leave a Comment on Tax Implications of Unwinding a 1031 Exchange

Let’s face it. Times have changed. The tumultuous real estate market, renovations over budget, difficult tenants combined with the challenging job environment have resulted in questions about how to unwind a 1031 exchange. Imagine ten years ago, we survived the Y2K scare and were approaching the tech market bubble burst. Real estate appreciation was gaining traction. Washington was promoting regulations to help those interested in securing a home. Ten years is not a lot of time when you are young. But when you have experienced the depths of job loss, foreclosure and declining retirement portfolio your perspective changes questioning why not sell the rental property and cash out.

Three Reasons Why Unwinding a 1031 Exchange Makes Sense Before 2013

Every market is cyclical, which helps cleanse inefficiencies and to adopt new strategies. Adjusting to change is a maturing process requiring us to take note of the whole and the individual pieces. Three reasons why unwinding a 1031 exchange makes sense includes:

  • Historically low federal capital gains rate of 15% will sunset on December 31, 2012 to 20%. In 2013, federal capital gains will increase 3.8% Medicare tax for those earning over $200,000.
  • If in the ten or fifteen percent income tax bracket, your long term federal capital gains tax rate may be even lower than 15%.
  • Divorce and changing partnership interests: it may make sense to consider cashing out the partner and continue the tax deferral in another 1031 exchange if you want to continue holding real property.

Unwinding a 1031 Exchange

The first place to start is talking with your accountant to understand the tax consequences. If you are selling a replacement property purchased in a prior exchange, is you will have two sets of taxes, one due on the replacement property and a second set due on the original property sold. Questions to consider include:

  • What is your current federal income tax bracket?
  • Were the investment properties itemized on Schedule E?
  • Was depreciation taken on Schedule E of your tax return?

Your accountant will look to determine the adjusted basis of each property to determine the estimated recognized gain or tax due. The tax bill may not be as bad as you think. But not understanding the tax implication could also be quite risky.

We Can Help 

Atlas 1031 Exchange has been accommodating tax-deferred exchanges of all kinds for more than 17 years. We are fluent in the rules and regulations of IRC Section 1031 and able to help you navigate your exchange.

Contact us today to discuss any questions you may have. Call our office at 1-800-227-1031, email us at info@atlas1031.com, or submit your question through the online form at the top of this page.