1031 Exchanges Open Many Opportunities for Investors
For over 85 years, taxpayers have taken advantage of a tax strategy referred to as a 1031 exchange. Section 1031 of the Internal Revenue Code allows the deferral of gain on the sale and purchase of property held for use in a trade or business or for investment. Most taxpayers that take advantage of 1031 exchanges have one objective: avoiding the tax now. Unfortunately, many do not realize the many other benefits of an exchange.
When selling a property held for use in a trade or business, the seller must pay capital gain tax on all property appreciation. Many know the maximum capital gain tax rate for assets held more than twelve months by an individual is 15%, but few realize that you must also recapture all depreciation taken on the property at a flat rate of 25%. If the asset was held for a long period of time, the depreciation recapture can create a significant tax liability. A 1031 exchange will not only defer the capital gains but also the depreciation recapture. Learn how you can benefit from a 1031 exchange. (click to this whole article which should be added to the top of the benefits of a 1031 exchange.)
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For a taxpayer with high income or those that are pushed into a high income bracket as the result of the sale may fall into alternative minimum tax (AMT) and be taxed at an even higher rate. Often times the exchange can save a taxpayer from AMT. Taxpayers who wish to exclude some of the sale proceeds and pay tax on the trade down are often surprised when the amount excluded pushes them into AMT.
With the historically low mortgage rates available the last few years, many property owners have refinanced their properties and pulled out as much equity as possible. Lately, we have seen numerous taxpayers complete an exchange simply because the actual tax liability is greater than the net equity in the property. An exchange prevents the taxpayer from taking money out of pocket to cover the taxes.
While many recognize the short term benefits associated with the tax deferral, few seem to realize the long term benefits of a 1031 exchange. The long term time value of the deferral is very powerful. An exchange provides taxpayers with the ability to use PRE-TAX dollars to acquire real estate. As long at the taxpayer continues to use the property for use in a trade or business or for investment, the taxpayer can continue to exchange the property for other property instead of completing a taxable sale. It is only when a property is sold without an exchange that a taxable event is triggered.
To defer all gain, the taxpayer is required to acquire a replacement property equal or greater to the net selling price of the relinquished property and it must have equal or greater equity. A loophole in the regulations allows a taxpayer to refinance after the replacement property is acquired and take equity without creating a taxable event. This not only provides the taxpayer with the ability to accomplish complete deferral under section 1031 but also the opportunity to use the equity for whatever he wishes. This equity could be used to acquire other properties, diversify his assets (stocks, bonds, etc.) or make capital improvements to another property.
Many taxpayers also do not know that when title is held in an individual name (and not an entity) the gain is forgiven upon the death of the taxpayer. When one passes away, his or her heirs receive the property with a stepped up basis (meaning the value of the property at the time of death) and no one has to pay back the deferred gain. Of course, taxpayers should seek advice on how to minimize the estate taxes.
When the taxpayer is an entity, the gain can be deferred indefinitely.
Exchanges also allow the taxpayer the ability to increase income by acquiring a newer property, one with more units, one that is easier to rent, one that yields higher rental income or even multiple properties. A taxpayer can also acquire a property with less management responsibilities, such as a NNN property or Tenant-in-Common (TIC) interest.
As replacement property, the taxpayer can acquire a property that he or she intends to eventually use as a vacation home or a primary residence (both of which do not qualify under section 1031). After maintaining the property as a rental, the taxpayer could convert it to a personal use property without triggering a taxable event. If used as a primary residence, once the taxpayer has owned the property for at least five years and used it as a primary residence for at least 24 months of those five years, the taxpayer can sell the property and take advantage of the exclusion allowed under IRC section 121. This provision allows a single taxpayer to exclude up to $250,000 of gain ($500,000 for married taxpayers) once every two years. Note that section 121 never excludes depreciation recapture so the taxpayer would have to recapture deprecation taken (but only back to May 6, 1997).
In summary, an exchange is much like an interest free loan from the IRS that allows you to increase the principal and may never require repayment. The more a taxpayer knows about 1031 exchanges, the more he or she can maximize the benefits and use pre-tax dollars to grow his or her real estate portfolio.
✴ Immediate tax avoidance
✴ Time value of deferred gain
✴ Greater buying power
✴ Greater selling power
✴ Increased income potential
✴ Less management responsibility
✴ Diversification of investments
✴ Consolidation of properties
✴ Relocation of investment property or business
✴ Expansion of business location
✴ Opportunity to depreciate higher basis replacement property
✴ Tax may be forgiven upon death of Taxpayer (heirs may receive stepped up basis)
✴ Defers appreciation gain as well as depreciate recapture
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