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Tax-Free Real Estate Exchanges

Jul 6, 2021SML Planning Minute Podcast, Company News, Retirement Planning

Episode 133 – Tax-free real estate exchanges have long been a favored technique used to defer capital gains taxes. How do they work, and are they still viable with tax changes coming?

Transcript of Podcast Episode 133

Savvy real estate investors have been saving money for decades by using so-called “tax-free exchanges” under Section 1031 of the Internal Revenue Code. Understanding these exchanges can help property owners defer significant amounts in capital gains taxes. Here’s how they work. Section 1031 has been with us for 100 years—almost as long as the income tax itself. Today it is most commonly applied to rental real estate. Let’s say you’ve owned a rental property for many years. Assume you purchased it 20 years ago for $100,000, but it’s now worth $200,000, and you’d like to sell it.

Keep in mind that depreciation expense is one of the key elements used when investing in rental real estate. This means that each year, you can offset some of your income with a non-cash expense that is deducted, but not actually paid in cash. Most U.S. residential buildings are depreciated over 27.5 years, which works out to roughly 3.6 percent per year.

Getting back to our simplified example, let’s assume you had rental income one year of $10,000 and expenses of $7,000. So your net cash flow was $3,000. But because of depreciation, even though you made money that year, for tax purposes you would show a loss of $600.

Depreciation works well while you are operating your rental property. But the bad news comes when you sell it. When you take depreciation against your property, it reduces your “tax basis.” This has the effect of increasing your taxable gain. In our example above, your basis would be reduced by $72,720. That $72,720 of depreciation you took over those 20 years would now be part of your taxable gain, and subject to capital gains taxes of up to 20 percent. And it could be higher when you include state capital gains taxes. When you add in the gain on the actual appreciation of the property, you could be looking at a sizeable tax bill.

Enter IRC Section 1031. The IRS will allow you to defer the entire capital gain tax if, within a reasonable timeframe, you purchase a “like kind” property of at least the same value. But the rules are somewhat complex.

For one thing, you are given 45 days from the time of the sale to identify the replacement property. The identification must be in writing, and the property must be clearly described. In other words, you need to describe the full address of the new property or its legal description. Recognizing that there can always be unanticipated issues, the IRS will allow you to provide a list of up to three potential replacement properties. If the first one falls through, you can always select one of the other two. You just have to close on the new property within six months.

For another thing, when you sell the first property, you cannot take control of the proceeds. The money goes into an escrow account of a “qualified 1031 facilitator,” also known as a “qualified intermediary,” only to be used later for the new property.

Perhaps most important, the new property must be “substantially the same” as the old one. But the rules on this are surprisingly flexible. You can exchange a house for a condo, an apartment building for raw land, or a farm for a strip mall.

But what happens if the new property is less expensive than the one you’re selling? If you have cash left over after everything is done, that cash, often referred to as “boot,” will generally be taxed as a capital gain.

One final note. On the campaign trail in 2020, Biden officials stated that they will take aim at “so-called like kind exchanges,” which led experts to believe that 1031 exchanges may be targeted for high-income individuals. In his “American Families Plan” introduced in late April, President Biden announced a plan to limit the capital gains break on a 1031 exchange to transactions under $500,000.

The Biden plan would also raise the top marginal income tax rate from 37 percent to 39.6 percent. And for taxpayers with incomes above $1 million, the long-term capital gains rate would also increase to 39.6 percent. Further, when his budget plan was released on May 28, President Biden also proposed making the capital gains tax changes retroactive to April 2021. This provision was designed to prevent wealthy taxpayers from quickly selling off assets to avoid the increase.

Of course, an increase in capital gains taxes alone—without any corresponding change to 1031 exchanges—would only serve to make Section 1031 exchanges more attractive.

Anticipated changes should heighten awareness of the importance of estate planning for real estate investors. Estate plans should certainly be re-evaluated and liquidity needs reassessed. Obtaining additional life insurance may be prudent or at least worth considering as tax law changes emerge.

Disclaimers: Tax laws are complex and subject to change. The information presented is based on current interpretation of the laws as of the date of publication, is intended for general information purposes only, and does not constitute legal or tax advice. This information is not intended or written to be used, and cannot be used, for the purpose of avoiding penalties that may be imposed on the taxpayer under the Internal Revenue Code or any other applicable tax law. Taxpayers are advised to seek tax advice based on their particular circumstances from an independent tax advisor. Neither Security Mutual nor its agents are permitted to provide tax or legal advice.

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