This year the federal Tax Cuts and Jobs Act demolished the 1031 exchange tax deferment benefit of personal property. This means that personal property (primary residences, vacation homes, artwork and collectibles) are no longer deferable.
The change caused initial confusion about how the IRS would handle the exchange of properties such as: office buildings, warehouses, and self storage facilities. To the relief of Real Estate Investors, Congress retained the 1031 benefit for real property, how ever this does not grant the ability to swap properties at will.
Why Use a 1031 Exchange?
As an investor, there are a number of reasons why you may consider utilizing a 1031 exchange. Some of those reasons include:
- You may be seeking a property that has better return prospects or may wish to diversify assets.
- If you are the owner of investment real estate, you might be looking for a managed property rather than managing one yourself.
- You might want to consolidate several properties into one, for purposes of estate planning, for example, or you might want to divide a single property into several assets.
- Reset the depreciation clock.
The main benefit of carrying out a 1031 exchange rather than simply selling one property and buying another is the tax deferral. A 1031 exchange allows you to defer capital gains tax, thus freeing more capital for investment in the replacement property.
It’s important to keep in mind, though, that a 1031 exchange may require a comparatively high minimum investment and holding time. This makes these transactions more ideal for individuals with a higher net worth. And, due to their complexity, 1031 exchange transactions should be handled by professionals.
What Is Depreciation and Why Is It Important to a 1031 Exchange?
Depreciation is an essential concept for understanding the true benefits of a 1031 exchange.
Depreciation is the percentage of the cost of an investment property that is written off every year, recognizing the effects of wear and tear. When a property is sold, capital gains taxes are calculated based on the property’s net-adjusted basis, which reflects the property’s original purchase price, plus capital improvements minus depreciation.
If a property sells for more than its depreciated value, you may have to recapture the depreciation. That means the amount of depreciation will be included in your taxable income from the sale of the property.
Since the size of the depreciation recaptured increases with time, you may be motivated to engage in a 1031 exchange to avoid the large increase in taxable income that depreciation recapture would cause later on. Depreciation recapture will be a factor to account for when calculating the value of any 1031 exchange transaction—it is only a matter of degree.
What is a Like-Kind Exchange
You must reinvest in a similar property through a "like-kind exchange." Like-kind property is property of the same nature, character or class. Quality or grade does not matter. Most real estate will be like-kind to other real estate.
Rules of a 1031 Exchange
One should consult with their CPA or financial advisor to understand the benefits of a 1031 exchange. To reap these financial benefits you need to identify the Like-Kind replacement property within 45 days in writing. This is crucial and does not lock you into one property. When searching for the replacement property it is common to write several letters of intent to acquire the property. You then have 180 days from when you closed escrow on the sale of your property to complete the exchange.
1031 and Estate Planning
One of the major benefits of participating in a 1031 exchange is that you can take that tax deferment with you to the grave. If your heirs inherit property received through a 1031 exchange, its value is “stepped up” to fair market, which wipes out the tax deferment debt.
This means that if you die without having sold the property obtained through a 1031 exchange, the heirs receive it at the stepped up market rate value, and all deferred taxes are erased. An estate planner should be consulted to take maximum advantage of this opportunity. Tenancy in common can be used to structure assets in accordance with your wishes for their distribution after death.
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