A 1031 Exchange (Tax-Deferred Exchange) Is One Of The Most Powerful Tax Deferral Strategies Available For Taxpayers
In a nutshell, a 1031 Exchange allows an investor to sell a property, reinvest the proceeds in a new property and defer all capital gain taxes.
The Internal Revenue Code Section 1031(a)(1) states:
“No gain or loss shall be recognized on the exchange of real property held for productive use in a trade or business or for investment if such real property is exchanged solely for real property of like kind which is to be held either for productive use in a trade or business or for investment.”
The benefits of IRC Section 1031 Exchanges can be tremendous! Investors are often able to defer thousands of dollars in capital gain taxes, both at federal and state levels. If the requirements of a valid 1031 Exchange are met, capital gain recognition will be deferred until the taxpayer chooses to recognize it. This essentially results in a long- term, interest-free loan from the IRS.
TYPICAL SALE VS. 1031 EXCHANGE
An investment property owner sells a rental property for $400,000. The owner originally purchased the property for $200,000. There is $200,000 of debt and the property has been fully depreciated. The capital gain is approximately $350,000 (assuming 75% of the property is depreciable). If the investor does not do an exchange, federal capital gain taxes would be:
- $150,000 (depreciation recapture) x 25% = $37,500
- $200,000 (capital gain balance) x 15% = $30,000
- $350,000 Capital Gain Taxes Owed $67,500
The state taxes owed (where applicable) would need to be added to the federal taxes due. Assuming the property owner sold in the District Of Columbia, the following additional taxes would need to be paid:
- State level (DC) 8.5%, $350,000 x 8.5% = $29,750
- Total Capital Gain Taxes (Fed. & State) $97,250
The next comparison analyzes the value of the new property that could be acquired in a sale versus an exchange. The comparison assumes an investor makes a 25% down payment and finances 75% of the property (75% loan-to-value ratio).
| SALE | 1031 EXCHANGE | |
|---|---|---|
| Equity | $200,000 | $200,000 |
| Capital Gain Tax | $97,250 | $0 |
| Cash to Reinvest | $102,750 | $200,000 |
| 75% LOAN-TO-VALUE | ||
| New Property | $411,000 | $800,000 |
As the above example demonstrates, tax-deferred exchanges allow investors to defer capital gain taxes as well as facilitate significant portfolio growth and increased return on investment. In order to access the full potential of these benefits, it is crucial to have a comprehensive knowledge of the exchange process and the Section 1031 code. For instance, an accurate understanding of the key term like-kind – often mistakenly thought to mean the same exact types of property – can reveal possibilities that might have been dismissed or overlooked.
LIKE-KIND PROPERTIES
There is some confusion regarding what type of property qualifies for a 1031 Tax Deferred Exchange. The Internal Revenue Code Section 1031 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.”
“Like-kind” property can include, but is not limited to, any of the following, provided it is held for investment:
- Single Family Rental
- Duplex
- Apartment
- Commercial Property
- Raw Land
For example, raw land can be exchanged for a single family rental, or apartments or a commercial building. Properties can be exchanged anywhere within the United States.
BENEFITS TO REAL ESTATE INVESTORS
Section 1031 Tax Deferred Exchanges continue to increase in popularity as more investors nationwide discover the wide range of investment objectives that can be easily met through exchanging.
The real power of a tax deferred exchange is not just the tax savings — it is the tremendous increase in purchasing power generated by this tax savings! With the advantages of leverage, every dollar saved in taxes allows a real estate investor to purchase two to three times more real estate. Many investors are surprised to discover that capital gain taxes are far higher than 15%. State taxes, which can be as high as 11% in some states, are added to the federal capital gain taxes owed. In addition, depreciation deducted over the ownership period is taxed at a rate of 25%. The net result is often a large percentage of an investor’s profits going directly to pay taxes.
The most common reasons for a 1031 Exchange:
Preservation of Equity – A properly structured exchange provides real estate investors with the opportunity to defer 100% of both Federal and State capital gain taxes. This essentially equals an interest-free, no-term loan on taxes due until the property is sold for cash! Most often, the capital gain taxes are deferred indefinitely because many investors continue to exchange from one property to the next, dramatically increasing the value of their real estate investments with each exchange.
Leverage – Many investors exchange from a property where they have a high equity position or one that is “free and clear” into a much more valuable property. A larger property produces more cash flow and provides greater depreciation benefits, which therefore increase an investor’s return on their investment.
Diversification – Exchangers have a number of opportunities for diversification through exchanges. One option is to diversify into another geographic region such as exchanging one apartment building in Denver, Colorado for two additional apartments – one in Los Angeles, California and the other in Dallas, Texas. Another diversification alternative is acquiring a different property type, such as exchanging from several residential units to a small retail center.
Management Relief – Some investors accumulate several single family rentals over the years. The ongoing maintenance and management of what can be a far-reaching group of properties can be lessened by exchanging these properties for one property better suited to on-site maintenance and management. Exchanging into a single apartment complex with a resident manager is a good example of this strategy.
Estate Planning – Often a number of family members inherit one large property and disagree about what they want to do with it. Some want to continue holding the investment and some desire to sell it immediately for cash. By exchanging from one large property into several smaller properties, an investor can designate that, after their death, each heir will receive a different property that they can either hold or sell.
Non-Tax Motives for Exchanging – In addition to the deferral of capital gain taxes, there are many underlying reasons an investor would want to exchange one property for another. These are some of the typical non-tax motives for performing an exchange.
- Exchange from depreciated property to higher value property that can be depreciated.
- Exchange from property that cannot be refinanced, such as land, to improved property that will support a new loan thereby gaining the ability to obtain cash.
- Exchanging from non-income land to improved property to create cash flow.
- Exchange from already appreciated property, such as an apartment, to a high cash flow property, such as a retail center, to generate needed cash flow.
- Exchange from cash flow property to property with faster appreciation (for clients who do not have immediate need cash flow needs but wish to build their real estate portfolio).
- Exchange for a property or properties that may be easier to sell in the coming years.
- Exchange to meet the location requirements of a client who has moved across the country or one who simply wishes to invest in a different part of the city.
- Exchange to fit the lifestyle of a client, for example, a retiree may exchange for a property requiring reduced management in order to travel more.
- Exchange from several smaller properties into a larger one to consolidate the benefits of ownership, or exchange from a larger property to several smaller ones to divide an estate among children or for retirement reasons.
- Exchange to a property an investor can use in her own profession, for example, a doctor may exchange out of rental houses into a medical building she can use for her practice.
- Exchange out of a partial interest in one property to a full interest in another.
- Exchange into a singe family rental property that will initially be held for investment. At a later date the investor may decide to move into this property and convert it into their primary residence. Under current tax laws, after the investor has lived in the property as their primary residence for 2 out of 5 years, they are eligible for the tax exclusion benefits available under IRC Section 121.
- Exchange into a rental property at a resort location that is desirable and where property values typically appreciate well in good economic times.
- Exchange out of a management intensive ranch or farm operation for a lower management burden of an apartment complex with an on-site property manager.
- Exchange depreciated equipment or vehicles for similar new equipment or vehicles.
1031 EXCHANGE FAQs
- ACTUAL RECEIPT: Physical possession of proceeds.
- ALTERNATIVE MINIMUM TAX: Under the tax law, certain tax benefits can significantly reduce a taxpayer’s regular tax amount. The alternative minimum tax (AMT) applies to taxpayers with high economic income by setting a limit on those benefits. It helps to ensure that those taxpayers pay at least a minimum amount of tax.
- BOOT: “Non like-kind” property received; “Boot” is taxable to the extent there is a
- capital gain.
- CAPITAL GAIN: Capital gain is an increase in the value of a capital asset (investment or real estate) that gives it a higher worth than the purchase price. The gain is not realized until the asset is sold. A capital gain may be short-term (one year or less) or long-term (more than one year) and must be claimed on income taxes.
- CASH BOOT: Any proceeds actually or constructively received by the Exchanger.
- CONSTRUCTIVE RECEIPT: Although an investor does not have actual possession of the proceeds, they are legally entitled to the proceeds in some manner such as having the money held by an entity considered as their agent or by someone having a fiduciary relationship with them. This can create a taxable event.
- COST BASIS:
- DEPRECIATION RECAPTURE: Depreciation recapture is the gain received from the sale of depreciable capital property that must be reported as income. Depreciation recapture is assessed when the sale price of an asset exceeds the tax basis or adjusted cost basis. The difference between these figures is thus “recaptured” by reporting it as income.
- DIRECT DEEDING: Transfer of title directly from the Exchanger to Buyer and from the Seller to Exchanger after all necessary exchange documents have been executed.
- EXCHANGER: Entity or taxpayer performing an exchange.
- EXCHANGE AGREEMENT: The written agreement defining the transfer of the relinquished property, the subsequent receipt of the replacement property, and the restrictions on the exchange proceeds during the exchange period.
- EXCHANGE PERIOD: The period of time in which replacement property must be received by the Exchanger; Ends on the earlier of 180 calendar days after the relinquished property closing or the due date for the Exchanger’s tax return (If the 180th day falls after the due date of the Exchanger’s tax return, an extension may be filed to be entitled to the full 180 day exchange period).
- IDENTIFICATION PERIOD: A maximum of 45 calendar days from the relinquished property closing to properly identify potential replacement property or properties.
- LIKE-KIND PROPERTY: Any property used for productive use in trade or business or held for investment; both the relinquished and replacement properties must be consid- ered “like-kind” to qualify for tax deferral.
- MORTGAGE BOOT: This occurs when the Exchanger does not acquire debt that is equal to or greater than the debt that was paid off on the relinquished property sale; Referred to as “debt relief”. This can create a taxable event.
- NET PROCEEDS: Net proceeds are the amount the seller receives after all costs and expenses are deducted from the gross proceeds arising from the sale of an asset.
- QUALIFIED INTERMEDIARY: The entity who facilitates the exchange; Defined as follows: (1) Not a related party (i.e. agent, attorney, broker, etc.) (2) Receives a fee (3) Receives the relinquished property from the Exchanger and sells to the buyer (4) Purchases the replacement property from the seller and transfers it to the Exchanger.
- RELINQUISHED PROPERTY: Property given up by the Exchanger; Referred to as the sale, ‘downleg’ or ‘Phase I’.
- REPLACEMENT PROPERTY: Property received by the Exchanger: Referred to as the purchase, ‘upleg’ or ‘Phase II’.