When 1031 Deferred Gain is Forgiven

A Powerful Wealth Building and Estate Preservation Tool

A 1031 tax-deferred exchange enables investors to build their real estate portfolio with pre-tax dollars but is also a powerful estate preservation tool.

While a 1031 exchange is tax-deferral strategy, there are ways to completely avoid the tax. And you can do many exchanges during your lifetime. Essentially, with your first exchange you create an I Owe You (IOU) to the IRS and each time you do a subsequent exchange, you add to that IOU. If you sell a property without doing a 1031 exchange, some or all of that IOU will have to be paid to IRS.  If you never sell without exchanging, when you pass away, your heirs inherit your property with a stepped up basis (which means at the fair market value at the time of death). A stepped up basis erases the IOU to IRS and your heirs will not have to pay any tax on the gain you deferred. Using 1031 exchanges, you have the opportunity to build your real estate portfolio using pre-tax dollars – creating a larger portfolio and greater cash flow. The ultimate strategy is to defer, defer, die.

Once the property is inherited by your heirs, they can immediately sell without paying any capital gains. Keep in mind, depending on the size of your estate, there may be estate taxes due and you would be wise to work with a financial advisor to do some good estate planning and minimize the tax consequences. Through the end of 2012, there is a $5,000,000 exemption from estate taxes and anything after that is taxed at 35%, the lowest estate taxes have ever been. It sounds almost too good to be true but that is the way it works and what makes 1031 such a powerful estate preservation tool. 

There is a way to avoid some of the gain without leaving this earth. Many of us spend significant time planning for our retirement and saving as much money as possible to ensure a comfortable life and the continuance of our current life style. Believe it or not, a 1031 exchange might provide some benefit. 

Under Section 121 of the Internal Revenue Code, if you own a property and use it as your primary residence for 24 of the last 60 months, you are entitled to a $250,000 (if single) exclusion on the sale of the property provided you have not taken that exclusion within the past 24 months. Married taxpayers filing jointly are entitled to a $500,000 exclusion. An exclusion is a wonderful thing as there is no requirement to pay taxes on it or reinvest.  Why I bring up this primary residence exclusion is because there is a way to take advantage of it when selling property acquired in a 1031 exchange. 

Consider a scenario that is typical along the Jersey Shore. Assume George and Martha purchased a property for $250,000 twenty years ago and is now selling for $1,000,000. To estimate how much may be due first we have to recapture the depreciation taken during the twenty years the property has been held as a rental at 25% (regardless of tax bracket). John and Mary took $150,000 in depreciation and recaptured at 25% would have to pay $37,500.  Next George and Martha must determine how much they must pay in capital gains. Their appreciation is $750,000 (the difference between the $1,000,000 sale price and the original purchase price of $250,000). The maximum capital gain tax rate (through 12/31/12) for individuals who have held an asset for at least 12 months is 15%.  The capital gain tax liability would be $112,500 ($750,000 x 15%).  The total tax due would be $150,000 but with an exchange, George and Martha have the opportunity to use the $150,000 towards replacement property.  Let’s assume they use the money to acquire two new Shore properties and intend to use both as rentals.  After renting for a number of years (and using each property for a week or two each summer), George and Martha decide they are ready to retire and would like to live at the Shore year round.  They can sell their current primary residence (assuming they have owned it for at least 24 months) and qualify for the $500,000 primary residence exclusion. Next George and Martha can move into one of the two properties (with a lot of money in the bank!) and after living there for two years, can sell it and exclude $500,000 of gain again.  There a few rules to keep in mind if the home was acquired in a 1031 exchange but typically your tax savings are significant. 

To sum it all up, a 1031 exchange is like an interest free loan from the federal government; you can increase the principal by doing subsequent exchanges and if planed properly never requires repayment. Don’t overlook the power of 1031 exchanges. They can help you acquire not only short-term investment objectives but also many long-term ones.