WHAT IS A 1031 EXCHANGE?
A 1031 Exchange allows a real estate property owner or investor in real estate to make a tax deferred exchange.
WHO IS ELIGIBLE FOR A 1031 EXCHANGE?
Any real estate property owner or investor of real estate, should consider an exchange when he/she expects to acquire a replacement property (known as “like kind”).
WHEN SHOULD I INITIATE A 1031 EXCHANGE?
After examining the facts and tax benefits, once you decide a 1031 Exchange is something you want to initiate, the process is set in motion before selling the present property.
HOW DO I GET THIS STARTED?
Your real estate agent will be able to refer you to a licensed 1031 agent in your area. They set up the paperwork and follow through with the process.
WHAT ARE SOME OF THE BENEFITS OF THE 1031 EXCHANGE?
Without a 1031 Exchange in place, the sale of a property would necessitate the payment of a capital gain tax, which is currently 15%, but may go to 20% in future years. Federal and state tax rates of your given state should also be considered when doing a 1031 exchange.
The main reason for a 1031 is that the IRS depreciates capital real estate investments at a 3% per year rate as long as you hold the investment, until it is fully depreciated. When you sell the capital asset, the IRS wants to tax you on the depreciated portion as an income tax, and that would be at the marginal tax rate. ‘
CAN YOU GIVE ME AN EXAMPLE?
If you hold an investment for 15 years, the IRS depreciates it 45%. It then wants you to pay the taxes on that 45% depreciation. If combined state and federal taxes are 35% at the marginal rate, that’s about 15% of the cost of the property (one third of 45%). If your property is fully depreciated, it becomes the whole 35% marginal tax rate.
Another way to make it easy to understand is when purchasing a replacement property (without the benefit of a 1031 exchange) your buying power is reduced to the point, that it only represents 70-80% of what it did previously (before the exchange and payment of taxes).
Below is a look at the basic concept, which can apply to all 1031 exchanges. From the sale of a relinquished real estate property, we should understand this concept so that we can completely defer the realized capital gain taxes. The two major rules to follow are:
1. The total purchase price of the replacement “like kind” property must be equal to, or greater than the total net sales price of the relinquished, real estate, property.
2. All the equity received from the sale, of the relinquished real estate property, must be used to acquire the replacement, “like kind” property.
The extent that either of these rules (above) are violated will determine the tax liability accrued to the person executing the Exchange.
In any case which the replacement property purchase price is less, there will be a tax responsibility incurred. To the extent that not all equity is moved from the relinquished to the replacement property, there will be tax. This is not to say that the 1031 Exchange will not qualify for these reasons. Keep in mind, partial exchanges do in fact, qualify for a partial tax-deferral treatment. This simply means that the amount, of the difference (if any), will be taxed as a “BOOT” or “non-like-kind” real estate property.
WHAT IF THE RULES CHANGE?
IRS tax rulings do change all the time. For current information on how a 1031 Exchange is structured today, have your real estate agent put you in touch with an expert on exchanges. They will be able to provide you with everything you need to make an educated decision about this option.