If you invest in real property, especially real estate, you can take advantage of some very specialized opportunities for tax planning. Section 1031 of the Internal Revenue Code permits some tax-deferral strategies when buying and selling real property. In general, a “1031 Exchange” allows you to defer capital gains taxes on any profits when you sell real property as long as you reinvest the proceeds from that sale in a replacement property within a certain amount of time.
Before we delve into the details of a 1031 Exchange, it is important to note that the provisions of and the transactions that qualify under Section 1031 are very complex. If these transactions are not handled carefully, the transaction could lose the eligibility for favorable tax treatment. Therefore, you should consult appropriate tax and legal professionals before undertaking a 1031 exchange.
If you decide to sell one piece of property in order to buy another one, you would normally pay capital gains taxes any amount of net-adjusted proceeds from that sale that are greater than zero. This is calculated as follows:
Depending on the size and type of this capital gain, you may want to consider using a 1031 Exchange for this transaction. Quite simply, a 1031 Exchange allows you to postpone, or defer, the taxes on the sale of real property if the proceeds from the sale are invested in a qualifying, similar property.
A 1031 Exchange can be particularly useful when you need to manage specific tax situations. For example, if a property sells for more than its depreciated value, the difference in value caused by depreciation must be “recaptured” and taxed.
To realize these benefits, you must make sure that the 1031 Exchange transaction adheres to certain rules, the most important of which is that the transaction must involve “real property” of a “like kind” nature. In a real estate transaction, real property is generally considered to be land and buildings. When determining whether properties are “like kind,” it is important to focus on the type of property involved and not its quality or its state of repair.
For example, selling an apartment building and using the proceeds to purchase vacant land generally would be considered a like kind exchange as long as both properties are located in the United States. A broad range of property types are eligible for such exchange and the exact definitions of qualifying properties can be found in the Internal Revenue Code.
Let’s say you decide to sell an office building you bought for $5 million seven years ago and on which you have made $275,000 in capital improvements. Over those seven years, the property depreciated $125,000. This makes your adjusted basis $5,150,000:
$5,000,000 purchase price + $275,000 in capital improvements - $125,000 in depreciation
If you sell the office property for $6,100,000 after expenses related to the sale, your net realized gain will be $950,000:
$6,100,000 net sale price - $5,150,000 adjusted basis
As a real estate investor, you have already found another property to purchase with the proceeds from this sale. In this case, the new property has a total purchase price of $6,250,000. If this purchase closes within 180 days of the sale of the office building, you have the option to complete a 1031 exchange and defer capital gains taxes on that transaction and depreciation recapture on the sold property. This allows you to use the full realized gain of $950,000 towards the purchase of your new investment property. A 1031 Exchange offers a very specialized and favorable tax treatment if you meet all the required conditions. It is always best to involve an expert in the field of law and taxation when considering or executing such a transaction, as rules and definitions do change from time to time. A 1031 exchange could be disqualified if it does not adhere to all required provisions.
In Part 2 of this series, we will discuss some of the special considerations and situations you may encounter with a 1031 Exchange.
Contact a Blue Chip Partners financial advisor today to learn more about your tax planning options.
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