1031 Exchange – What you need to know
A 1031 exchange allows you to defer the capital gains tax due on the sale of a piece of real property by rolling the gain into any other type of real property. A qualified intermediary must complete the 1031 exchange and there are very specific rules that must be adhered to.
The total capital gains tax calculation as of 2013:
- Taxation on depreciation recapture at 25%
- Federal capital gains taxes at 20% (or 15%)
- 3.8% Medicare surcharge tax on net investment income
- State tax rate (0% - 13.3%)
Medicare and Federal Capital Gains tax depend on your taxable income
Single |
Married |
Cap Gains |
Medicare |
Combined Rate |
$0 - $36,250 |
0 - $72,500 |
0% |
0% |
0% |
$36,251 - $200,000 |
$72,501 - $250,000 |
15% |
0% |
15% |
$200,001 - $400,000 |
$250,001 - $450,000 |
15% |
3.8% |
18.8% |
$400,001 + |
$450,001 + |
20% |
3.8% |
23.8% |
A 1031 Exchange can be an expansion from one property into many, a consolidation from many properties into one or a partial exchange where money is taken out of the exchange.
Cash taken out of the exchange is known as cash boot and will be taxed at the full capital gains tax outlined above. Mortgage boot is also taxable and will be covered later in this article.
To qualify for a 1031 exchange, the property must meet the following rules:
- Intent on the property is to hold for investment
- Facts and circumstances back up intent to hold for investment
- Paper trail backing up intent to hold for investment
As you can see, intent for the exchanged property is of great concern to the IRS. The time period for which the property must be held for investment is not defined by the IRS. The shorter that time period, the higher the red flag for audit.
Vacation homes can qualify for exchange if the vacation home was primarily held for investment. The vacation home will be considered held for investment if the following requirements are met.
- The relinquished property and replacement property must be held by the taxpayer for a least 24 months.
- Within each of these two 12 month periods, constituting the qualifying use period, the taxpayer must:
- Rent the property at fair market value for a period of 14 or more days.
- The taxpayers personal use of the property can’t exceed the greater of 14 days or 10% of the total time rented.
A common question: “How would the IRS ever know if I used the vacation home?”
The IRS has access to anything they need in order to prove their case. This includes access to your ATM records, access to your credit card statements, access to your cell phone records, etc. If you lie to the IRS it constitutes as tax fraud.
Rules for the most common 1031 Exchange, a delayed exchange.
- Time Requirements
- Taxpayer must identify potential replacement property(s) by midnight of the 45th day from the sale of the relinquished property.
- Taxpayer must acquire the replacement property by midnight of the 180th day or the date the Taxpayer must file its tax return, whichever is earlier.
- Identification Rules
- 3 Property Rule – Can identify up to 3 replacement properties with and unlimited total market value. You can also unidentify as many times as necessary to stay within the 3 property rule. Taxpayer must acquire one of the identified properties.
- 200% Rule – Unlimited amount of identified properties but the total market value of all identified properties must not exceed 200% of the relinquished property. Taxpayer must acquire one of the identified properties.
- 95% Rule – Taxpayer may identify an unlimited number of properties with an unlimited total market value. Taxpayer must acquire 95% of the identified properties.
- Identification must be:
- Made in writing
- Unambiguously describe the property
- Hand delivered, mailed, telecopied, or otherwise sent
- Sent by midnight of the 45th day
- Delivered to the Qualified Intermediary
The Exchange Equation
For a full deferral the taxpayer must meet two requirements:
- Reinvest all the net exchange proceeds
- Acquire property with the same or greater amount of debt
Example 1 – No Boot: In this example the replacement property has a higher debt amount and no cash is taken out, so there is no boot and therefore no tax liability.
|
Relinquished |
Replacement |
Boot |
Value |
$900,000 |
$1,200,000 |
|
- Debt |
$300,000 |
$660,000 |
$0 |
- Cost of Sale |
$60,000 |
|
|
Net Equity |
$540,000 |
$540,000 |
$0 |
Total Boot |
|
|
$0 |
Example 2 – Mortgage Boot: In this scenario the replacement property has a lower debt amount creating mortgage boot. So there is a capital gain tax liability on the $40,000 mortgage boot despite the fact that all the proceeds from the transaction were invested in the replacement property.
|
Relinquished |
Replacement |
Boot |
Value |
$900,000 |
$800,000 |
|
- Debt |
$300,000 |
$260,000 |
$40,000 |
- Cost of Sale |
$60,000 |
|
|
Net Equity |
$540,000 |
$540,000 |
$0 |
Total Boot |
|
|
$40,000 |
The real power of the 1031 Exchange
If you defer the capital gain taxes, how much does your purchasing power increase?
1st Calculate Net Adjusted Basis |
|
|
|
Original Purchase Price (Basis) |
$500,000 |
|
plus Capital Improvements |
$50,000 |
|
minus Depreciation |
$150,000 |
|
equals Net Adjusted Basis |
$400,000 |
2nd Calculate Capital Gain |
|
|
|
Sales Price |
$800,000 |
|
minus Net Adjusted Basis |
$400,000 |
|
minus Cost of Sale |
$60,000 |
|
equals CAPITAL GAIN |
$340,000 |
3rd Calculate Capital Gain Tax Due |
|
|
|
Recaptured Depreciation (25%) |
$37,500 |
|
plus Federal Capital Gain Tax (20%) |
$38,000 |
|
plus Medicare Surcharge (3.8%) |
$12,920 |
|
plus State Tax (CO 2.9%) |
$9,860 |
|
TOTAL TAX DUE |
$98,280 |
4th Calculate After Tax Equity |
|
|
|
Sales Price |
$800,000 |
|
minus Cost of Sale |
$60,000 |
|
minus Loan Balance |
$300,00 |
|
equals Gross Equity |
$440,000 |
|
minus Capital Gain Tax Due |
$98,280 |
|
equals After Tax Equity |
$319,960 |
REINVESTMENT OF SALE |
|
|
|
After-Tax Equity x 4 |
$1,279,840 |
REINVESTMENT OF EXCHANGE |
|
|
|
Gross Equity = Net Equity |
$440,000 |
|
Gross Equity x 4 |
$1,760,000 |
|
|
|
INCREASE IN PURCHASE POWER |
$480,160 |
The equity multiplier mentioned above assumes that that equity from the sale will be used as a 25% down payment on the replacement property keeping the loan to value at 75%.
How to select a Qualified Intermediary (QI)
- Does the QI offer written backing of a large creditworthy entity?
- What is the financial rating and balance sheet of the backing entity?
- Does the QI conduct due diligence on the depositories holding the funds and monitor them?
- Does the QI offer segregated accounts?
- Does the QI offer a qualified escrow account?
- Does the QI offer a qualified trust account?
- Does the QI have sufficient fidelity bond coverage?
The Neir Team Endorses Scott R. Saunders with Asset Preservation, Inc as a Qualified Intermediary. www.apiexchange.com
The information in the article was provided by Scott E Saunders with Asset Preservation, Inc.
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