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.
EXAMPLE
Consider the Following:
- An investor has a $200,000 capital gain and incurs a tax liability of approximately $70,000 in combined taxes (depreciation recapture, federal and state capital gain taxes) when the property is sold. Only $130,000 remains to reinvest in another property.
- Assuming a 25% down payment and a 75% loan-to-value ratio, the seller would only be able to purchase a $520,000 new property.
- If the same investor chose to exchange, however, he or she would be able to reinvest the entire $200,000 of equity in the purchase of $800,000 in real estate, assuming the same down payment and loan-to-value ratios.
As the above example demonstrates, exchanges protect investors from capital gain taxes as well as facilitating 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 IRC. 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.
Questions about 1031 Tax Deferred Exchanges? Contact Andrew J. Treuting, managing attorney of our commercial services department and resident expert on 1031 Tax Deferred Exchanges.
504.525.1491
atreuting@titlestream.com
Q+A
The requirements for full tax deferral are different than the capital gain tax and/or basis computations. Click onCapital Gain Calculation to determine your approximate capital gain tax liability.
If an Exchanger intends to perform an exchange that is fully tax deferred, they must meet two simple requirements:
1. Reinvest the entire net equity (net proceeds) in one or more replacement properties.
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2. Acquire one or more replacement properties with the same or a greater amount of debt.
An alternative approach for complete tax deferral is acquiring property of equal or greater value and spending the entire net equity in the acquisition. One exception to the second requirement is that an Exchanger can offset a reduction in debt by adding cash to the replacement property closing.
WHAT IS BOOT?
The term boot refers to any property received in an exchange that is not considered “like-kind.” Cash boot refers to the receipt of cash. Mortgage boot (also called debt relief) is a term describing an Exchanger’s reduction in mortgage liabilities on a replacement property. Any personal property received is also considered boot in a real property exchange transaction.
If the Exchanger receives cash or other property in addition to like-kind property, this may result in a taxable event. To determine the taxes that may be due, several steps are required. First, the Exchanger’s tax advisor must calculate the realized capital gain. Second, the amount of boot, money or other property received, along with any depreciation recapture, must be determined. Finally, a tax advisor will review the Exchanger’s specific situation to see if there are additional tax issues that may offset any current capital gain tax liabilities.
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.
EXAMPLE:
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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: |
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The state taxes owed (where applicable) would need to be added to the federal taxes due. Assuming the property owner sold in California, the following additional taxes would need to be paid: |
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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). |
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SALE VS. AN EXCHANGE |
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This example illustrates that the real power of a tax deferred exchange is not just the tax savings – it is the increase in purchasing power generated by this tax savings! |
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ADVANTAGES OF A 1031 EXCHANGE |
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Real estate held as “stock in trade or other property primarily for sale” is excluded from the tax deferral benefits of IRC Section 1031. Stock in trade describes property which is included in the inventory of a dealer and is held for sale to customers in the ordinary course of business. The gain on the sale of this property is taxed as ordinary income.
SUBSTANTIATING THE INVESTMENT INTENT
To qualify for a §1031 exchange, a taxpayer must be able to support that their “intent” at the time of the purchase was to hold the property for investment. Listed below are some factors the IRS may review to determine whether or not the intent was to hold the property for investment. The burden of substantiating the investment intent is the responsibility of the taxpayer and the items below are not an exhaustive list but provide useful indicators in determining the taxpayer's intent.
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The purpose for which the property was initially acquired.
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The purpose for which the property was subsequently held.
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The purpose for which the property was being held at the time of sale.
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The extent of advertising, promotion of other active efforts used in soliciting buyers for the sale of the property.
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The listing of property with brokers.
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The extent to which improvements, if any, were made to the property.
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The frequency, number and continuity of sales.
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The extent and nature of the transaction.
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The ordinary course of business of the taxpayer.
CAN A DEALER PERFORM AN EXCHANGE?
The fact that a taxpayer is considered a dealer does not automatically disqualify them from performing an exchange. A dealer may segregate assets that they intend “to hold for productive use in a trade or business or for investment” from their dealer property. Some dealers have been advised by their attorneys to form a separate entity, such as an LLC, specifically to hold title to property that may be able to qualify for an exchange sometime in the future.
REVIEW WITH LEGAL AND/OR TAX ADVISORS
It is important that all taxpayers, and particularly dealers, review their transaction with an attorney or accountant before proceeding with an exchange. There are many issues not covered in this short discussion which may affect the ability of a taxpayer to successfully defend an exchange transaction.
There are three steps involved in determining the capital gain taxes that are owed. The first is to determine the net adjusted basis – this is calculated by starting with the original purchase price, adding the capital improvements and subtracting the depreciation taken. The second step is calculating the actual capital gain by taking today’s sales price, subtracting the net adjusted basis and then subtracting the cost of sale to arrive at the capital gain. The third, and final step, is determining the capital gain owed. Under this formula, the recaptured depreciation is all taxed at 25% and the remaining economic gain is taxed at the maximum capital gain tax rate which is currently 15%. Finally, the state tax rate, when applicable, is also applied to the capital gain. All three of these amounts, the depreciation recapture, the federal amount and the state tax, are added to arrive at the total capital gain tax due.
The identification period in a delayed exchange begins on the date the Exchanger transfers the relinquished property and ends at midnight on the 45th calendar day thereafter. To qualify for a §1031 tax deferred exchange, the tax code requires identifying replacement property:
- In a written document signed by the Exchanger;
- Hand delivered, mailed, telecopied, or otherwise
- Before the end of the identification period to;
- Either the person obligated to transfer the replacement property to the Exchanger [generally the "Qualified Intermediary"] or any other person involved in the exchange other than the taxpayer or a disqualified person.
An identification notice must contain:
- An unambiguous description of the replacement property
(i.e. legal description, street or distinguishable name) - Exchangers should note the address of the relinquished property
- The type of property should be described in a personal property exchange
ADDITIONAL IDENTIFICATION ISSUES
Exchangers acquiring a property which is being constructed must identify this property and the improvements in as much detail as is practical at the time the identification is made. Exchangers who intend to acquire less than a 100% ownership interest in the replacement property should specify the specific percentage interest. Exchangers should always consult with their tax and/or legal advisors about the specific identification rules and restrictions.
Any properties acquired within the 45-day identification period are considered properly identified. An investor has the ability to substitute new replacement properties by revoking a previous identification and correctly identifying new replacement properties as long as this is done in writing within the 45-day identification period.
Although Exchangers can identify more than one replacement property, the maximum number of properties that can be identified is limited to:
- Three properties without regard to their fair market value (3 Property Rule);
- Any number of properties so long as their aggregate fair market value does not exceed 200% of the aggregate fair market value of all relinquished properties (200% Rule);
- Any number of properties without regard to the combined fair market value, as long the properties acquired amount to at least ninety five percent (95%) of the fair market value of all identified properties (95% Rule).
A reverse exchange is the purchase of the replacement property prior to closing on the relinquished property. An investor may need to consider a reverse exchange in a seller's market, where properties are selling quickly and inventory is scarce. The most common variation (often called "parking the replacement property") involves the Qualified Intermediary first purchasing the replacement property. When the relinquished property is sold at a later date, the Qualified Intermediary completes the exchange by deeding the replacement property back to the Exchanger. It is especially crucial that the Qualified Intermediary has in-depth knowledge of the steps and precautions necessary in these complex transactions. Working with an investor's tax advisers and attorneys, API draws upon substantial experience with reverse exchanges to help lead the investor safely through a minefield of potential hazards.
In a partial exchange, the investor decides to defer some capital gain taxes and also pay taxes on either 1) cash proceeds received or 2) a reduction on their replacement property debt obligations - both of these events result in the receipt of boot which refers to any property received in an exchange that is not considered like-kind. [Cash boot refers to the receipt of cash. Mortgage boot is a term describing an Exchanger's reduction in mortgage liabilities on a replacement property. Any personal property received is also considered boot in a real property exchange transaction.]
The central issue is whether or not the investor has the intent to “hold for investment”, not just the period of time. There is no “safe” holding period to automatically qualify as being held for investment. Time is only one of the factors the IRS can look at to determine the exchanger’s intent for both the relinquished and replacement properties. Every investor has unique facts and circumstances and it is up to them, and their tax or legal advisors, to be able to substantiate that their primary intent was to hold property for investment purposes.