If you own highly-appreciated business or investment real estate that you wish to sell, you can possibly avoid capital gains tax by exchanging it for new property of a like kind. A Section 1031 exchange can help you defer capital gains tax on appreciated property indefinitely and possibly eliminate it permanently.
What is a 1031 Exchange?
A 1031 exchange allows a taxpayer to postpone their long-term capital gains tax when selling an investment property by exchanging both the basis and the gain into a new investment property. This gives financial leverage, as the taxes you would have paid to the IRS are now working to earn you money. The foundation of the 1031 exchange rule by the IRS is that the properties involved in the transaction must be “like kind” and both properties must be held for a productive purpose in business, trade or as an investment. Despite the term, “like kind,” you can exchange an apartment complex for a commercial property or a piece of land for a shopping center because real estate is generally like-kind.
To effectively defer the capital gains tax in an exchange, you must ensure that you never possess or control the sale proceeds. And the best way to do that is to use one of the IRS safe harbors. The most popular safe harbor involves the use of a qualified intermediary (QI) who receives and holds the proceeds from the sale of the relinquished property and uses them to purchase the replacement property. The QI is an independent third party who holds the sales proceeds and purchases the replacement property on your behalf. Other safe harbors include qualified escrow accounts and qualified trusts.
To qualify for tax deferred treatment under the IRS safe harbor, you must identify the replacement property within 45 days after you sell the property you are relinquishing and complete the purchase within 180 days after the initial sale. There is no limit on how many times you can implement a 1031. You can roll over the gain from one piece of investment real estate to another, then another and another. You may have a profit on each swap, but you can avoid tax until you actually sell the property for cash, or you receive proceeds or debt reduction from an exchange.
A similar safe harbor, known as a reverse exchange, allows you to engage a QI to acquire replacement property before you sell relinquished property. To defer capital gain, you must identify the relinquished property within 45 days and complete the sale within 180 days. To avoid holding title to relinquished and replacement properties at the same time, you must hold replacement properties with an exchange accommodation title holder until the transaction is completed.
1031 Exchange as Part of Your Estate Plan
Although a Section 1031 exchange is best known as a tax-deferral technique, it is also a powerful estate planning tool. Ordinarily, when you sell appreciated real estate, you must pay federal income taxes on the gain at rates as high as 20%, leaving less to pass on to your heirs. If you hold onto property for life, however, the capital gains disappear. Your heirs receive a stepped-up basis in the property equal to its fair market value on your date of death, erasing any previous appreciation in value and allowing them to turn around and sell the property tax-free.
This strategy is particularly effective if your estate will be exempt from federal estate taxes. But if your estate is large enough to make federal estate taxes a concern, weigh the income tax benefits of a 1031 exchange against the potential estate tax costs.
Depending on your situation, you may also want to consider gifting property to your heirs during your life. The gift will be subject to gift tax and your heirs will not receive a stepped-up basis in the property, but any future appreciation in value will be removed from your taxable estate. However, you may prefer to dispose of property in order to invest in income-producing real estate or to diversify your holdings. That is where a Section 1031 exchange comes into play. Rather than selling property, paying capital gains taxes and reinvesting what’s left of the proceeds, an exchange allows you to accomplish your goals without losing any of the exchanged property’s value to taxes.
Under the right circumstances, 1031 exchanges provide real tax savings and are an excellent wealth accumulation vehicle.
For more information, contact Veronica Olguin at 312.670.7444. Visit ORBA.com to learn more about our Wealth Management Group.