Capital gains-now or later: A 1031 Exchange may be the solution
During tax season my father, a W.W.II veteran used to say, “I am proud to be an American and have fought for its freedoms, but I could be just as proud for half as much.”
I certainly agree and I am sure many of us feel this way.
There are a number of ways to accomplish this, legally of course, thru IRAs, pension and profit-sharing plans, Roth IRAs and more. If you are a real estate investor, a tax-free exchange or 1031 Exchange is an excellent method of sheltering taxable gains.
A tax-free exchange is a method of selling a capital asset, like real estate, according to certain prescribed rules and procedures in a manner that all or most of the capital gains taxes will be deferred to the future. It may help to think that the taxpayer is not selling a capital asset but is reorganizing his or her investments. Congress decided this reorganization was not a taxable event if conducted in accordance with certain rules.
Let’s start with some definitions. Long-term capital gains stem from assets you’ve held for more than a year. Short-term capital gains are from assets held for a year or less.
For most of us in 2016, and until further notice, the tax rate on long-term capital gains is 15 percent, while those in the top bracket pay 20 percent and those in the 10 percent or 15 percent tax brackets pay no taxes on those capital gains.
Those earning more than $200,000 (filing single) or more than $250,000 (joint filing) may also have to pay a 3.8 percent Net Investment Income Tax, which is pegged on to help fund the ACA, or Obamacare.
For short-term gains, the capital gains tax rate is your ordinary tax rate, which could be in the 33-40 percent range if you’re a high earner. For most of us, it will be 25-28 percent.
If paying even 15 percent on your long-term capital gains seems unpleasant, buck up, because you don’t always have to pay it.
If you have more losses than gains, you can use up to $3,000 of losses to offset your overall taxable income, and any more than that can be carried forward into future years.
The following is an example of the 1031 exchange process. The following compares a typical sale and a 1031 exchange.
Bill decided to sell the condominium he has owned for six years, relinquishing the property. The property’s current fair market value is $1.5 million. However, at the time he purchased the condo, the FMV was $500,000. After Bill spent $50,000 in capital improvements and the property depreciated by $80,000, his adjusted cost basis was $470,000. Bill was advised by his tax consultant to engage in a tax-deferred exchange.
Bill’s real estate broker discovered an apartment building for $2.75 million, the replacement property. Bill purchased the property using the net proceeds from the sale of his condo within the 180-day period and successfully completed the 1031 exchange. If Bill had sold his condo without using a 1031 exchange, he would have paid $144,500 in federal taxes.
Through the use of a 1031 Exchange, Bill deferred his capital gains and depreciation recapture taxes, and had $144,500 more to invest into a replacement property.
For reasons other than tax savings investors may want to exchange property.
The client is determined to sell for some or any reason, due to the age of neighborhood or maintenance expenses or whatever.
The client is tired of residential rentals and wants commercial or vacant land.
The client wants to switch into faster-appreciating investments.
The client wants to get rid of appreciated non-income-producing vacant land and buy income-producing investments.
The client sells fully depreciated property and buys a more valuable property, thus creating a new tax shelter and avoiding the recapture (tax) on the depreciation.
The client wants to leverage up his or her investments.
The client wants to defer payment of tax liability to take advantage of the “time value of money.”
The client wants to rearrange his or her holdings in anticipation of death.
The client mistakenly thinks that selling is the only way to secure much needed cash.
The client wants his or her investment property to be near his or her principal residence.
Tax-free exchanges are allowed by the IRS for property held for the productive use in trade or business and investment property.
Tax-free exchanges are not allowed by the IRS on: personal residences; second homes; time-shares purchased for personal use; inventory property (property held primarily for sale); capital assets held for business such as equipment for equipment, or cows for cows NOT bulls — true. They qualify — I am not kidding.
Meeting the deadlines is extremely important. There are two dates you must remember. The 45-day rule, which is the time you have to identify the property. And the 180–day rule, which is the time you have to acquire the property.
The common mistake is that people add these together. It is 180 days total — the 45 days is included in the 180 days and therefore is a total with steep penalties if not adhered to.
And there are other rules you should know about.
The three-party rule – the exchanger (the person doing the 1031 Exchange) may identify three properties of any value. The vast majority of exchangers are required to follow this rule. A property cannot be added if the identified property falls off the list after the first 45 days or the 200 percent rule – the exchanger may identify more than three properties if the total fair market value of what is identified does not exceed 200 percent of the sales price of the sold or relinquished property.
Or the 95 percent rule – if the exchanger exceeds the three-property rule and the 200 percent rule the exchange will not fail if they purchase 95 percent of the aggregate fair market value of all identified properties.
Following basic rule of reinvestment, use all the cash in the exchange account with an equal or greater amount of debt and exchange like kind property.
There are plenty of other rules and nuances as each one of these transactions are all different depending on your investment and financial goals, the reason you are trading the property, parties involved, whether you are an individual, corporation or LLC.
For these reasons you must have a good team one which includes your CPA, attorney, commercial realtor, lender and exchange facilitator.
[panel title=”About Dennis Gisi” style=”info”]
Dennis Gisi, is the owner of John L. Scott in Pasco. Gisi is also the retired president, CEO and a former chairman of Bank Reale in Pasco.