1031 Tax Deferred Exchange
A 1031 Exchange can also be called a tax-deferred exchange. This is simply a method of selling one specifically qualified property in order to purchase another specifically qualified property within a limited time frame.
The process of buying one property and then immediately purchasing another is very similar to other types of “buying and selling” transactions, but with a 1031 Exchange, the transaction is basically treated as if you are exchanging one property for another, rather than buying and selling.
This distinctive difference of “exchange” often results in the property owner qualifying for tax-deferred capital gains. To put this in more simple terms, selling property is considered taxable income by the IRS while 1031 Exchanges are not.
A 1031 Exchange can prevent you from having to pay a significant amount of tax on capital gains. Another consideration is your state and federal income tax rates; Capital investments of real estate depreciate at a rate of 3% per year for the total length of time in which you own the property, according to the IRS.
Once you sell any type of capital asset, the IRS will automatically want you to claim the depreciated amount on your income taxes at the marginal tax rate.
For example; let’s say that you have owned a specific investment property for approximately 15 years.
At a 3% depreciation rate per year, the IRS has now considered your investment to depreciate by 45%.Once you sell this property, the IRS will expect you to pay taxes on this 45% depreciation value.
In cases where combined federal and state income taxes have a marginal rate of 35%, this is tantamount to 15% of the total cost of the property, or one third of the 45% depreciation. If the property is considered to be fully depreciated, then it becomes the entire 35% marginal tax rate.
Perhaps an easier-to-understand example would be the purchasing of a piece of real estate replacement property without the use of a 1031 Exchange, resulting in only 70% to 80% of your original purchasing power when you consider the payment of taxes before the exchange.
Listed below are the common criteria which would apply to all types of 1031 Exchanges. In order to defer the potential capital gains taxes when selling a piece of real estate, we should thoroughly understand this concept before proceeding.
The following are the two major rules regarding 1031 Exchanges:
- The total amount of the purchase price for the replacement property must be at least “equal to or greater than” the total price of the relinquished property.
- Any equity from the sale of the relinquished property must be used solely for the purpose of acquiring the replacement property, otherwise the remaining balanced will be taxed.
If either one of these two rules are violated, then the property owner will become liable for a portion of additional income taxes. There will always be an additional tax levied against the property owner in all cases where the replacement property price is less than the price of the relinquished property.
In cases where only a portion of the equity is used to purchase the replacement property, there will also be an additional penalty tax based on the percentage used. However, partial exchanges can still qualify as a 1031 Exchange. They simply result in a partial deferral of the capital gains.
If you have questions, you can contact us here or call 1-877-273-7823