Let’s Talk About the 1031 Exchange (Tax Deferral Series) - Episode 1

For the next few weeks, I’ll spend a little time explaining to you some of the tax benefits of utilizing IRC 1031 (“1031 exchange”) and its tremendous amount of benefits that only real estate investors can take advantage. I believe the 1031 exchange is one of the most misunderstood areas of tax law and yet one of the most important areas of the code to master especially as you are considering buying properties by trading up the value ladder.

Today we’ll cover the core mechanics and as the weeks progress, I’ll delve into different slices of the code which will empower you with the knowledge to go out and start buying new property.

The Basics

In a typical sale of an investment, we are taxed on the gain recognized which is a function of the sale price (or net sales price after factoring in costs) less the adjusted basis of the investment. The tax rate on this gain would either be taxed at the taxpayer’s marginal tax bracket at its ordinary rate if the investment if held for under 1 year and would be taxed at 15% or 20% depending on the taxpayer’s taxable income, notwithstanding any surtaxes on net investment income or state income taxes, if held for more than 1 year. For ease of discussion, we’ll always assume capital gains taxed at long term rates will be taxed at 20% to the taxpayer.

To demonstrate how this works, let’s look at two investments:

Marketable Security

Taxpayer Tom acquires 100 shares of XYZ Corp for $1,000. The same lot of shares appreciates to $1,500 2 years later. Taxpayer Tom decides to click the sell button on his online trading account and realize AND recognize a gain of $500 ($1500 sale price minus $1,000 basis) and pay taxes of $100 (20% of the $500 gain). Pretty simple.

Rental Property

Taxpayer Tom acquires an 8 unit apartment building for $120,000 (give me a call if you know of such an opportunity by the way). On the date of acquisition, Tom performs an analysis with his CPA and allocates $20,000 to the land and $100,000 to the building. Throughout the years of holding the asset, Tom deducted $40,000 of depreciation expenses against his taxable income, which leaves the building’s adjusted basis at $80,000 ($120,000 purchase price less $40,000 of depreciation deductions). He sells it for $210,000 and realizes and recognizes a gain of $130,000 ($210,000 less $80,000 of adjusted basis). He pays $28,000 in total taxes on his IRC 1231 gain which is taxed at long term capital gains rates of 20% and 25% on the depreciation previously taken under IRC 1250. Also pretty straightforward.

But what if Tom could take that $28,000 and invest it in more property instead of handing it over to the IRS?

1031 to the Rescue

This is where IRC 1031 comes into play. Under current law as of the time this post was written, a taxpayer can exchange real property for other real property for productive use in a trade or business or for investment and defer the gain realized to a later date. This would include anything that is considered real property under your state law such as fee simple interests in property, tenant in common interests, very long term leaseholds, and mineral rights such examples. What is excluded in eligibility to exchange are interests in corporate securities such as common stock even if it holds real estate. Also excluded are interests in a partnership, even if the partnership’s interest solely holds real property. So a taxpayer could not exchange shares of a Real Estate Investment Trust for an apartment building and take advantage of this code. Similarly, you won’t be able to sell a property and then use the proceeds to acquire a partnership interest in an office building. The exchange needs to be like kind (real property for real property). To be clear, like kind does not mean the same type of real property. You can exchange your Ritz Carlton condo in Downtown Los Angeles for farmland in Nebraska by way of example.

Provided that the taxpayer does not receive something called “boot” which is defined as unlike property to real estate, the taxpayer can avoid the recognition of the gain and thus have the money he would have paid in taxes still available to make more investments.

We’ll talk about the detailed mechanics of this in the next episode!

If you can’t wait until then to discuss, click here to reach out and get in touch.

-Stephen Morris, CPA, MBT, CCIM