“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. ” IRS, IRC Section 1031 (a)(1)
When selling investment property (non-owner occupied or not-principle residence) the seller may realize a hefty federal and state capital gains tax. One way to defer the tax is through the use of a 1031 Tax Deferred Exchange (1031 Exchange).
Currently, the gain is 15% of the “profit” (or 5% or 0% depending on tax bracket). In addition, the depreciation is also “recaptured” and payable upon the sale. The recapture is 25% of the depreciation (whether taken or not!). (There is a 15% rate for 10% or 15% bracket). (Note: These rates will probably increase in the coming years as the US Government looks for more ways to increase tax revenue to the US Treasury.)
To defer the capital gain, a seller of a property subject to capital gains can purchase another property and defer the tax. The basic 1031 rules are:
- Take title the same way you sold property
- Reinvest all cash proceeds (no “boot” allowed-otherwise “boot” taxed)
- Replace equal or greater debt
- 45 day identification period (can identify up to 3 properties)
- 180 days to complete exchange
- Qualified Intermediary must handle money
For real estate exchanges, if there is “dirt” underneath, then the exchange will probably qualify. (Sample exchanges include: condo for land, land for single family home, land for apartment building, single family home for shopping center, etc.)
Some examples that don’t qualify include: Personal/Primary residence, fix and flips, condo-conversions, vacation homes, land developments, etc.
For the investor wondering how the 1031 Exchange helps build wealth, consider this example:
Pay Tax : Investor sells a $200,000 property that he bought for $100,000 ten years (10) ago. The depreciation taken was $2,909 per year (house=$75,000, land=$20,000, closing cost=$5,000) or $29,090. If the investor pays the tax on his profit of $100,000, he would be left with $100,000 – $15,000 (15% tax) – $7,272 (25% depreciation recapture) = $77,728 (remember to subtract your states capital gains tax).
Using 1031 Exchange : Investor sells a $200,000 property that he bought for $100,000 ten years (10) ago. The depreciation taken was $2,909 per year (house=$75,000, land=$20,000, closing cost=$5,000) or $29,090. If the investor defers the tax on his profit of $100,000 and defers the depreciation recapture, he would be left with $100,000 to invest. (there is no state capital gains!)
Basically, you’ll save 15%+depreciation recapture (plus your states capital gain tax) of the profit by utilizing the 1031 Exchange. A great tax reducing strategy is to sell your investment properties in high tax states, buy replacement properties in a low/no tax state and then sell when your personal federal tax bracket is reduced or eliminated due to investment write-offs. Utilizing these tools, you can significantly reduce or eliminate your tax burden.