Tax-free Exchanges have been going on in the United States since the early 1920s! People would find a property that they liked and convince the owner to trade or swap properties with them.
However, exchanges today are not like what was experienced back then. They have evolved and gotten better! Congress passed Section 1031 of the Internal Revenue Code in 1954 and changed the name to 1031 Exchange – which is the Section of the Code (Section 1031) that refers to Tax-Free Exchanges.
Another interesting fact is that even though it is commonly referred to as a 1031 Tax-Free Exchange, it really isn’t Tax-Free. It is actually Tax-Deferred. However, tax-deferral is still a wonderful concept that can help you acquire greater wealth!
According to the IRS, US Code: Title 26, Section 1031, “No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of a like kind which is to be held for productive use in a trade or business or for investment”.
In other words, according to IRS rules, you cannot use a 1031 Exchange on your personal property, second home, vacation home or time share.
However, the 1031 Exchange has evolved and improved in such a manner that you no longer have to only “exchange” with someone else who is exchanging! As you can imagine, doing that kind of exchange is really difficult. Your pool of interested “Buyers” and your options for a new investment become so limited that it makes it almost impossible to perform this kind of exchange – although they still do occur!
Now, if you own a Residential Rental Property and you wish to sell it … you may sell it to anybody! And, you may purchase any other property that you wish … as long as you follow a few rules! (You knew there would be rules!)
Before we get into these though, let’s talk about one of the bright spots of owning an Investment Property: Depreciation!
Being able to depreciate investment properties (other than raw land) gives a nice tax benefit to investors.
Currently, owners of Investment Properties can reduce their taxes by using Straight-Line Depreciation of 27.5 years for Residential Investment Properties and 39 years for Commercial Investment Properties.
Straight-Line Depreciation means that you take the same amount of depreciation per year for the property. To compute the amount of depreciation, you take the purchase price of the investment property (minus the land value) and divide by 27.5 for residential properties or 39 for commercial. This figure is the amount you are allowed to sue on a yearly basis as your depreciation.
After taking the depreciation on your taxes for the applicable amount of time (either 27.5 years or 39 years – or until you sell the property, whichever is sooner) the property is then considered to be fully depreciated and you are not allowed to take the depreciation deduction any longer.
Please note, as mentioned earlier, land is NOT depreciable. If you sell an investment property outside of a 1031 exchange, you would owe capital gains tax on any profit, during the tax year of the sale. If you owned the property less than a year, you would owe short-term capital gains – over a year and you would owe long-term capital gains.
Please check with your tax advisor to find out the current applicable capital gains rates.
Let’s discuss why an investor might be interested in using a 1031 Exchange instead of just selling and buying another investment outright.
Why would I want to consider a 1031 Exchange?
• You are not ready to pay the capital gains! Perhaps you don’t feel you have enough cash lying around to pay it or maybe if you sold now it would be considered a short-term gain and you can’t afford it. Or, you would like to keep more of your money working for you.
• The property is fully depreciated! If the investment property is fully depreciated, perhaps it makes sense to move onto another property so that you may keep the depreciation deduction advantage!
• The property has appreciated nicely! This is every investor’s dream! However, you are concerned that if you sell the property now to lock in your gain you will have less buying power for another property because you have to pay a lot of capital gains taxes.
• You are moving! Not all investors want to own properties in a different city, let alone another state. Perhaps you had a sudden job transfer and now you are forced to incur a capital gain that you weren’t prepared for.
• Too much equity in the property! Some investors employ the power of leverage when it comes to investment properties. They feel that, by putting the minimum amount of their won cash into the deal and borrowing the rest, it frees up their cash for other things. In addition, the mortgage interest is a deductible item for tax purposes. Equity tied up in a property does not “earn” the investor any money.
• You want a different type of investment property! Maybe you own a single family investment property but would rather own a duplex. With a 1031 Exchange, you could sell the single family home, defer the capital gain and purchase the duplex.
• You don’t EVER want to pay capital gains taxes! As the saying goes, it is good to have a want! However, this “want” could truly become reality with the 1031 Exchange! It is possible for you to sell and purchase your investment properties with a 1031 exchange and defer all of the capital gains indefinitely! As an Estate Planning Strategy, heirs will inherit your 1031 Exchange Investment Properties with a full step-up in basis and without Federal Estate Taxes, up to the Estate Tax threshold (currently $5 million). This means that by using the 1031 Exchange as an Estate Planning tool, you never pay capital gains tax and your heirs don’t have to pay estate taxes on the value. WOW! That’s like having your cake and eating it too! it’s the gift that keeps on giving!