How to use a1031 Exchange to defer taxes

Real Estate

From Cindy Siok, Principal Broker, At Home Hawaii

With a relatively new president in the White House who campaigned on tax cuts, and Republican majorities in the House and Senate who have long been waiting, 1031 like-kind exchanges could be reformed or eliminated during the next phase of tax reform activity in Congress. So if there’s a 1031 exchange in your future – you might not want to wait too long to start that process.

When a property is sold for more than its original cost, the increase in value is something the IRS will tax. This is called a capital gains tax. The amount of capital gain gets a little complicated as it is calculated by taking the selling price of a property minus its "adjusted basis" (i.e. the original cost of the property, plus any amounts expended for capital improvements minus depreciation) minus selling expenses.

Capital gains are taxed at either 5 or 15 percent. The 5 percent rate applies to those falling in the 10 to 15 percent income tax brackets. The 15 percent rate applies to those in the 25 percent or higher income tax brackets. State capital gains tax may also apply. Additionally, any gain attributable to depreciation is taxed at 25 percent.

However, section 1031 of the tax code allows taxpayers to defer paying capital gains tax, if instead of selling an investment property and keeping the cash, the sellers reinvest the money into another real estate investment. Many investors exchange property using tax deferred dollars to diversify their assets and to increase their property portfolios.

Taxpayers should bear in mind the following rules: 1. Buy replacement property that is equal to or greater in value than the sold property; 2. Invest all cash proceeds from the sale of the relinquished property into the replacement property; and 3. Acquire debt on the replacement property that is equal to or greater than the debt that was on the relinquished property or add cash in place of debt.

Taxpayers contemplating an exchange should consult their tax advisor to determine their adjusted basis, their anticipated gain, their potential capital gains tax exposure, and whether the equities in the contemplated exchange property are balanced.

While avoiding capital gains taxes is usually the primary reason for engaging in a 1031 tax deferred exchange, there are other advantages to doing an exchange, including:

1. Replacing non-income producing property with income producing property;

2. Diversifying property interests for estate planning purposes;

3. Replacing time-consuming properties with more easily managed properties;

4. Exchanging into property that can accommodate the taxpayer’s trade or business;

5. Exchanging fully depreciated property to obtain the benefit of a new depreciation schedule;

6. For the relocation of a taxpayer’s business;

7. For the relocation of investment property to accomplish ease of management.

Aside from an experience real estate agent, you’ll need a qualified intermediary, like Old Republic Exchange to facilitate a 1031 Exchange. The intermediary will hold funds from the sale to use toward the new purchase in an escrow account.