WHAT IS IRC SECTION 1031?
Section 1031 of the Internal Revenue Code (IRC) allows a taxpayer who owns property held for investment or used in a business to exchange a relinquished property and defer paying federal, state capital gain taxes and depreciation recapture taxes if the taxpayer acquires a like-kind replacement property to be held for investment or used in a business following the rules and regulations of IRC §1031 and 1991 Treasury Regulations. This allows taxpayers to potentially use all of the proceeds from the sale of the relinquished property to leverage into more valuable property, increase cash flow, diversify into other properties, expand business operations, reduce management or consolidate into one larger replacement property.
WHAT IS LIKE-KIND PROPERTY?
There is some confusion regarding what type of property qualifies for tax deferral under IRC §1031. IRC §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 types of real property, provided it is held for investment: single-family rental, duplex, apartment, industrial commercial property or land. For example, land can be exchanged for a single-family rental or a multi-family property for a commercial building. Properties can be exchanged anywhere within the United States.
DOES A 1031 EXCHANGE NEED TO BE SIMULTANEOUS?
No, a 1031 exchange is rarely a two-party swap and done simultaneously. Most 1031 exchanges are delayed exchanges, whereby the taxpayer has 180 days between the sale of the relinquished property and the closing of the replacement property. The taxpayer must identify the potential replacement property(s) within 45 days from closing on the sale of the relinquished property.
WHEN IS A 1031 EXCHANGE APPLICABLE?
It is applicable whenever a taxpayer intends to sell any property that is not their primary residence or held for sale (and falls under the definition of like-kind property) and plans to purchase another like-kind property within 180 calendar days following the relinquished property closing. Paramount to any exchange is a competent and experienced qualified intermediary.
Thanks to IRC Section 1031, a properly structured 1031 Exchange allows an investor to sell a property, to reinvest the proceeds in a new property and to defer all capital gain taxes. IRC 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.”
To understand the powerful protection a 1031 exchange offers, consider the following example:
- Assume an investor has $400,000 in gain and also $400,000 in net proceeds after closing. Assuming an investor with a $400,000 capital gain and incurs a tax liability of approximately $140,000 in combined taxes (depreciation recapture, federal capital gain tax, state capital gain tax, and net investment income tax) when the property is sold. Only $260,000 in net equity remains to reinvest in another property.
- Assuming a 25% down payment and taking on new financing for the purchase with a 75% loan-to-value ratio, the investor would only be able to purchase a $1,040,000 replacement property.
- If the same investor chose to exchange, however, he or she would be able to reinvest the entire gross equity of $400,000 in the purchase of $1,600,000 replacement property, assuming the same down payment and loan-to-value ratios.
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. Asset Preservation, Inc. (API) is your resource to obtain accurate and thorough information about the entire exchange process.
LEVERAGING THE MARKET
Owners of investment properties struggle with finding ways to take advantage of the built-up equity in their income-producing properties and increase their return on equity while deferring payment of capital gains taxes. The current market environment encourages private investors to upgrade or reposition their real estate holdings.
MAKE INFORMED DECISIONS
While 1031 exchanges have gained increasing popularity, each investor should evaluate their own situation and objectives.
The first step is to have a qualified real estate agent evaluate your property to determine market value and then discuss the tax alternatives with your tax advisor. In some instances, it may be worth taking the cash and paying capital gains taxes, considering that interest rates remain historically low. Every asset is different and we can help you analyze to make informed decisions. On the other hand, an exchange may be the key to unlocking built-up equity and providing the opportunity to expand a portfolio and create greater wealth. The biggest mistake would be not to know your alternatives. We have built a team of qualified professional who specialize in these types of transaction.