Table those capital gains: 1031 exchanges
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Section 1031 of the IRS tax code allows an investor to defer the gains on a potential real estate sale if they purchase a property of similar nature and meet certain requirements as well as time constraints. How does this all work?
The Logistics
To qualify for a 1031 exchange, a few characteristics must be met. First, the property that you are selling (known as the relinquished property) and the property that you are purchasing (known as the replacement property) must be what the IRS deems “like-kind.” Once the properties involved have been established, you will need to incorporate the use of a qualified intermediary.
The intermediary’s responsibilities include:
- Coordinating with the seller of the replacement property
- Handling property documentation
- Holding funds from the sale of relinquished property
- Keeping records of all possible replacement properties
- Conveying title to the seller, amongst others
These steps ensure the entire process is handled succinctly and meets all established requirements.
The IRS also imposes a 180-day time limit for the exchange to be completed in totality. Within the first 45 days upon the sale of the relinquished property (aptly named the 45-day rule), you must identify potential replacement properties to the intermediary. Running concurrently, you must then close on a replacement property(ies) within 180 days of the sale of the relinquished property or after your tax return is due, whichever is earlier.
You will report the transaction on IRS form 8824 when the exchange is completed. Of note, only real property can occur in a 1031 exchange. Stocks, bonds, and partnership interests cannot be exchanged and qualify for a 1031 classification.
1031 Exchange – Example
Capital gain deferral is at the forefront of the 1031 strategy. To illustrate this strategy further, consider the following: You purchased an office building 15 years ago for $100,000 and today, that same building is valued at $700,000. You’ve decided that an office building elsewhere in town (valued at $1,000,000) has better long-term prospects, and you have decided it’s time to sell your current property and purchase a new one. If you sell the property outright, you would be required to pay capital gains tax amounting to $120,000 ($700,000 – $100,000 = $600,000 gain x 20%). If, however, you properly incorporate a 1031 strategy for the new building, those gains will be deferred.
The ‘exchange’ transaction would entail selling your current property (assuming you sold it for $700,000) and purchasing of the new property ($1,000,000). In this scenario, you would pay cash for the $300,000 shortage ($1,000,000 – $700,000 = $300,000). The basis of the new property would be $400,000. The new basis is calculated by adding the original property’s basis of $100,000 and the cash provided for the new property of $300,000. The $600,000 of capital gain in the original property continues to be deferred. This is an example of a Delayed Exchange is a case where the relinquished property is sold first and the replacement property is purchased afterward.
The reverse is also possible where the replacement property is purchased and the relinquished property is subsequently sold. This is suitably known as a Reverse Exchange.
Important Items of Interest
Be careful when exchanging depreciated property, as depreciation recapture, taxed as ordinary income, is possible. This could be triggered by an exchange where you move from improved land with a building to unimproved land with no building.
Another item of consideration is changing capital gains tax rates. It might make sense to defer capital gains in theory; however, if capital gains rates rise in the future, you may be stuck paying higher rates and subsequently more in taxes. From an estate planning perspective, the rules of a stepped-up basis apply if you pass while holding real estate assets that were obtained through a 1031 exchange. Your heirs will not be subject to taxes if the property is sold at the date of death.
Summary
Whether you are a highly experienced and savvy real estate investor or simply a novice, tax strategy plays an important role in how you manage and ultimately sell off properties. With so many moving parts in a 1031 exchange, you should work with professionals knowledgeable in this area, such as an estate planning attorney or tax accountant. You don’t want to get hamstrung with taxes, penalties, and interest for running afoul of the IRS.
Mathew Ryan, MBA, CFP®, EA is a Financial Planning Specialist with Bedel Financial Consulting, Inc., a wealth management firm located in Indianapolis. For more information, visit their website at www.bedelfinancial.com or email Mathew at mryan@bedelfinancial.com.