1031 Exchange comprises of a well-structured exchange of investment real estate. In a 1031 exchange sale, the investor does not ordinarily “swap” property with another investor. Rather, the investor trades one asset, and, within a specified time period, acquires replacement like-kind property.
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 get the benefit of this favorable tax treatment, investors looking to sell investment property should carefully examine whether re-investment in like-kind property is a suitable option for them.
1031 exchange got popular after IRS issued guidelines in Section 1031 of the U.S. Internal Revenue Code, which allowed parties to defer paying capital gains taxes upon the sales of an investment property and reinvest the proceeds of the sale within specified time limits in a property or properties of like kind which could be equal or greater in value. Sales involving 1031 Exchange are one of the most powerful wealth-building tools accessible to taxpayers. 1031 Exchange is considered a highly successful strategy by financial advisors. Investors get to defer taxes on the sale of the property till the time IRS rules are meticulously followed. 1031 Exchange sale is not only a brilliant strategy for saving taxes and promoting investment, but it also acts as a brilliant estate planning tool. In theory, an investor can defer capital gains on investment property indefinitely until death, possibly avoiding them altogether.
Let us understand this in detail considering the following example –
After a deal is closed, you as an investor have $400,000 in gain and $400,000 in net proceeds. Ideally, a $400,000 capital gain incurs a tax liability of approximately $140,000 in taxes which includes federal capital gain tax, state capital gain, tax depreciation recapture, and income tax on net investment, when a property is sold. $260,000 is what will remain in net equity to reinvest in a different property.
Let us consider a 25% down payment and availing on new financing for the acquisition with a 75% loan-to-value ratio, in this case, you will only be able to purchase a $1,040,000 replacement property.
However, if you chose to exchange, you will be able to reinvest the entire gross equity of $400,000 in the purchase of $1,600,000 replacement property, considering the same down payment and loan-to-value ratios.
As the preceding example explains, tax-deferred exchanges enable investors to defer capital gain taxes as well as promote meaningful portfolio growth and increases return on investment.
The benefits of 1031 exchanges sale can be notable for taxpayers who hold investment property. Taxpayers could defer all capital gain taxes, depreciation recapture, the net investment income tax (NIIT), and state taxes. Once the requirements of a valid 1031 exchange are met, capital gain recognition can be delayed until the taxpayer wishes to recognize it.
For instances, a married couple filing jointly trades an investment property in California for $1,000,000 (net of closing costs) with no debt. The couple incipiently acquired the property for $400,000. Seventy-five percent, or $300,000 of the initial purchase price, was designated to the building and has been fully depreciated. The capital gain is around $900,000 (today’s sales price of $1,000,000 minus the net adjusted basis of $100,000). This is the primary source of the couple’s investment income. The couple’s modified adjusted gross income is $1,400,000 (which includes income from other sources and capital gain from this sale) for purposes of calculating the net investment income tax. The couple will be taxed at 25% for their prior depreciation deductions taken, 20% federal capital gains tax rate, the 3.8% net investment income tax and they will be in the 13.3% California state tax bracket.
The benefits of IRC Section 1031 exchanges are enormous! Conversely, the impact of not doing an exchange can be simply mortifying. Investors are often qualified to delay hundreds of thousands of dollars in capital gain taxes, both at federal and state levels.
1031 Exchange enables your money to churn the maximum profit for you. However, the exchange process is extremely complex in nature and it would be wise to seek guidance from expert professionals. We have extensive experience in handling highly profitable exchanges for our varied client base.
For consultation and assistance regarding 1031 exchange call 888-993-2835 or email us at info@1031Xchange.com
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IRC Section 1031, IRC Section 1033, and IRC Section 721 are complex tax codes; therefore, all the investors/clients/consumers are advised to consult their tax and legal professional for details regarding their situation on any kind of investment. There are material risks every investor should know, associated with investing in 1031 Exchange properties, Delaware Statutory Trust (DST) and any other kind of Real Estate Properties. The risks include tenant vacancies; declining market values; potential loss of entire investment principal; that past performance is not a guarantee of future results; that potential cash flow, potential returns, and potential appreciation are not guaranteed in any way; adverse tax consequences and that real estate is typically an illiquid investment. This material does not constitute an offer to sell nor a solicitation of an offer to buy any security. Such offers can be made only by the Confidential Private Placement Memorandum. Please be aware that this material does not replace the PPM.