If you’re considering performing a 1031 tax exchange instead of a taxable sale of a property, this calculator will help you figure out your tax deferment for this course of action. First enter the price you originally purchased your property for, the dollar amount of capital improvements you’ve made, and the accumulated depreciation. Then input the price you sold the property for, selling expenses, both federal and state capital gains rates, and mortgage loan balances at sale.
Press CALCULATE and you’ll get a detailed, line-by-line breakdown of your tax deferment.
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7 Things to Know About 1031 Exchanges
Tax gurus and financial advisers have called Section 1031 of the tax code everything from the IRS’ best-kept secret to taxpayers’ single most powerful wealth-building weapon. With plaudits like that, the mysterious Section 1031 definitely merits further exploration. Simply put, Section 1031 allows taxpayers to swap an investment or business asset for another, thereby temporarily avoiding the dreaded capital gains tax. Read on for a more in-depth explanation of 1031 exchanges and what you need to know to leverage them as a financial tool.
Section 1031 Exchanges Defined
Also known as Starkers or like-kind exchanges, 1031 exchanges fall under an exception to the capital gains tax in the tax code. Normally, when you sell investment or business assets at a gain, you have to pay capital gains tax on that gain at the time of sale. Under Section 1031, taxpayers can postpone paying this tax if they reinvest the profit in similar property.
Doing so is known as a like-kind exchange, which allows taxpayers to grow their investment on a tax-deferred basis. Considering that long-term capital gains taxes are either 15 or 20 percent, and short-term capital gains rates range from 10 to 35 percent, these savings can be substantial. It’s always a good idea to consult a tax professional if you’re considering a 1031 exchange because it comes with a tome’s worth of fine print, but here are seven general things you should know.
1. Personal Property Usually Doesn’t Qualify
In the eyes of the IRS, there are five classes of property: trade or business property, property held for sale to customers, property used as a principal residence, investment property, and vacation home property. Only business, investment, and potentially vacation home property qualify for 1031 exchanges. In other words, you can’t exchange your primary residence for a new home and qualify for an exception.
According to the IRS, the commercial use of property is defined as holding “property for productive use in trade or business.” Investment property is property held for investment purposes rather than sale in the immediate future. For example, a property someone intends to fix and flip would not qualify under 1031 because it is held primarily for sale.
2. 1031 Makes Exceptions for Some Personal Property
Over 97 percent of 1031 exchanges involve real estate, but a growing percentage of these transactions involve personal property, such as artwork or airplanes. While 1031 doesn’t allow exchanges of stock and partnership interests, it does make exceptions for the following types of personal property (note: this list is illustrative, not exhaustive):
- Shipping vessels
- Paintings and other art
- Tenant-in-common interests
- Commercial or corporate aircraft
- Aviation and trucking equipment
- Trucks and car fleets
- Gold Coins
3. The Exchange Needn’t Be Instantaneous
The chances of finding another party who not only has the property you want but also wants the property you are selling are slim to none, which is why the IRS allows delayed exchanges under the 1031 exception. Also known as three-party or Starker exchanges (named after the controlling tax case), delayed exchanges require an intermediary to hold on to the money from the sale of your property. This middleman then uses the money to buy you a replacement property.
4. The IRS Uses “Like-Kind” Fairly Loosely
From the verbiage, you might get the idea of a rigid exception that demands the exchange of strip malls for strip malls, two-story apartment buildings for two-story apartment buildings. The reality is much more flexible. Here are a few examples of exchanges that qualify under 1031:
- One business for another
- A shopping center for a ranch
- Raw land for an office
- An industrial building for a single-family rental
5. Timing Is Everything
These exchanges have two very important rules governing the timing of the transaction. First, you have only 45 days to designate a replacement property in writing once you sell your original property. You must let the middleman know what property you want in exchange within this time frame and allow him to hold the cash so you don’t vitiate the 1031 treatment.
According to the IRS, you can designate up to three replacement properties so long as you actually end up closing on one. Another option is to designate as many replacement properties as you want, provided that their fair market value doesn’t exceed 200 percent of the aggregate fair market value of the exchanged properties.
6. You Have to Close on the Replacement Property within 180 Days of the Original Sale
The second timing rule is that you must close on the replacement property within six months of selling the old property. The clock starts ticking as soon as you close on the sale of the old property. For example, if you wait the full 45 days after the close of the sale of the old property to designate a replacement, that means you will have 135 days remaining to close on the replacement property.
7. Watch out for Tax “Snipers”
Investors tend to enter 1031 with boundless optimism that they will emerge with zero tax liability and a lucrative wealth-building strategy. While that is certainly possible, even 1031 exchanges have hidden tax liabilities, or “snipers,” build into them that can catch investors off guard. For example, if your intermediary purchases a replacement property that costs less than the proceeds from the sale of your original property, you will receive the difference in cash. That cash, called “boot” by the IRS, is taxable as a capital gain.
Additionally, even if you don’t receive cash from the transaction but your debt liability decreases, you will be taxed. For instance, if the mortgage on your original property was $500,000 and you exchange it for a property with a $300,000 mortgage, you will be taxed on $200,000 of boot.
A properly used 1031 exchange can help you grow your wealth substantially on a tax-deferred basis. By the time you cash the investment out, you will ideally have amassed a substantial gain that will be subject only to long-term capital gains, typically a rate of 15 percent. While promising, 1031 exchanges can be tricky, so make sure you receive proper tax counsel before embarking on one.