Orcas Island by Peter Drape

1031 Exchanges in a Nutshell Normally when you sell property, you must recognize a gain or loss in that transaction. If it is a gain, it is subject to tax (Federal capital gains tax, potential State income tax and potential depreciation recapture taxes). Section 1031 of the Internal Revenue Code (IRC), however, provides an exception to that general rule.

IRC §1031 states:
"No gain . . . shall be recognized on the exchange of property held for productive use in trade or business or for investment if such property is exchanged solely for property of like kind . . ."

The concept is simple: If you comply with IRC §1031, you are exchanging Property A for Property B. The sale proceeds from A are used to pay for the purchase of B, and by using a "Qualified Intermediary" (also called "Accommodator") to transfer both properties and funds, rather than you doing so directly, your tax liability is deferred.

Tax Savings Example

When selling investment property, you can generally expect to pay 15-25% of your capital gain in federal taxes, plus any applicable state taxes. Depending on the details of the transaction, this tax liability can be substantial. If your goal is to acquire other investment property while deferring the tax from your sale, a 1031 exchange is the only mechanism to accomplish that goal. The 1031 exchange is an invaluable tool for anyone selling and buying real estate.

For example, Investor A is evaluating whether to exchange a rental property. Since taxes are paid on the capital gain, the following calculation will help to estimate the potential Federal tax liability. Here are some facts related to this example:

Determine the Basis
Original Purchase Price	$500,000
PLUS Capital Improvements	(+) 25,000
LESS Depreciation	(-) 100,000
Adjusted Basis	$425,000
Determine Your Gain
Sale Price	$1,000,000
LESS Expense of Sale	(-) 80,000
Net Sale Price	$920,000
LESS Adjusted Basis	(-) $425,000
Realized Gain	$495,000
Determine Your Estimated Tax
Depreciation Recapture (25% x $100,000)	25,000
Capital Gains (15% x $395,000)	59,250
Estimated Federal Taxes Due	$84,250

In the above example, should investor A decide not to exchange, the taxable gain will be $495,000. This equates to federal income tax liability of $84,250 for Investor A, plus any state tax liability. By acquiring replacement property equal to or greater than the net sales price ($920,000) and reinvesting all sale proceeds, the entire gain will be deferred and no taxes will be due.

 

For more information or to begin the 1031 process go to www.1031info.com