Attempting to sell appreciated investment properties can include a significant tax decision. Many investors could have tens or hundreds of thousands of gains that could be taxable. To make matters worse, investors may have to recapture the depreciation they claimed in previous years. Highly appreciated real estate can be a struggle to move into another investment or liquidate when the time comes. While taxes should not solely determine your actions, using strategies like 1031 exchanges can help defer taxes and hopefully produce a better outcome.
The Problem
While there are a few different ways to defer or reduce taxes within real estate, 1031 exchanges may be one of the most popular. The intent of this tax strategy is to defer taxes by swapping your existing investment properly with a new one. There are quite a few rules to adhere to, but successful 1031 exchanges can hopefully reduce the taxable part of a real estate transaction.
The obvious savings are the capital gains that are deferred. Most people have heard of the primary residence exemption, where married couples are not subject to taxes on up to $500,000 in gains. This does not apply to the next property, like a residential or commercial rental property. Any large amount of gains, especially for a business owner, will likely be taxed at either a 15% or 20% capital gains rate. 20% on $500,000, for example, will require you to cut a check to the government for $100,000.
Using 1031 exchanges not only defers the capital gains tax but also any depreciation recapture. Usually, owners are very interested in depreciating their properties. In general, depreciation reduces your cost basis in the property. If the property is later sold for more than the cost basis, part of the taxes will include having to recapture the depreciation previously claimed. The IRS has capped this tax rate for real estate at 25%.
This could mean that after the entire sale, investors not using the 1031 strategy may take home only 60-70% of the proceeds of the sale (depending on what state you live in). Once people realize that they could lose $300,000 on a $1,000,000 property, it is easy to see why people look for solutions to reduce their taxes.
How to Qualify
There are only certain properties that this strategy can work for, which the IRS describes as “real property”. In simple terms, properties held for investment that usually produce income could qualify for the exchange. This includes rental property, business property, land, oil & gas interest, and a few others. Importantly, this means that primary residences and vacation homes would likely not qualify. For most investors, the property must be solely an investment, attempting to generate a profit.
There is also a strict timeline to complete the exchange. Since it can be logistically difficult to buy and sell two separate properties at the same time, there are Qualified Intermediaries (QI) who can help adhere to the IRS timeline. The typical period starts at the time you close on your current property, and then the QI takes the proceeds. 45 days from the closing, you need to identify a new property to purchase. 180 days from closing, you have to close and complete the transfer of any and all funds from the QI.
The new property purchased must also meet a few general restrictions. First, the property must be of equal or greater value than the previous one. Second, the latter transaction must include all of the equity from the former property. Third, you must obtain an equal or greater amount of debt than the previous property. This is a high-level overview of the different requirements with many nuances and exceptions, so do the research to understand what applies to your situation. Using a reputable QI, as well as experienced accountants and advisors, can make this process much smoother.
Benefits and Risks
There is no limit to the number of 1031 exchanges allowed, and therefore, you could defer your taxes indefinitely. This, at the very least, provides more tax planning opportunities. Knowing that you can indefinitely push the taxes into the future gives you more opportunity to pay that tax in a more favorable year. At the most basic level, this allows you to continue reinvesting money you would have paid in taxes to generate a higher return.
From an estate planning perspective, deferring the taxes until your death could, in theory, be the ultimate goal. Your beneficiaries would receive a stepped-up basis for the value of the current property at the time of your death, regardless of the number of previous 1031 exchanges involved. Not having to pay any of the capital gains you accrued over the years could turn into significant tax savings for the estate.
This strategy does not come without risk, though, so it is important to make sure you consult professionals about your specific situation. Purchasing new investment property brings all the same risks that previously existed (harder to liquidate, value could decrease, interest rates increase, etc.) while also adding any regulatory or legislative risk. While this is a great tax-deferral strategy if done correctly, the government could change the laws at any time and cause a significant tax bill if you are not ready for it.
1031 Exchanges
Tax-deferral strategies can be a great resource to help from a tax planning perspective. 1031 Exchanges can help push off the looming capital gains tax as well as the depreciation recapture. Focus on the exact steps to qualify for the exchange and make sure to include professionals to ensure it is correct. From then on, you can enjoy the benefits of tax deferral while still focusing your investments towards your financial goals.
TC Falkner 