Author: Greg Ribich, Vice President of Investor Relations
The 1031 exchange is commonly discussed in the real estate industry, but its full benefits are not widely understood. Likewise, the exchange comes with strict limitations that can, and do, reduce its appeal to certain investors.
When an investment property is sold at a profit, the capital gain on the sale often results in a significant tax liability. The portion of the gain that comes from depreciation recapture is taxed at a rate of 25 percent. The remainder of the gain is taxed between 15 percent and 20 percent depending on the tax bracket of the individual investor. Further, there is a 3.6 percent tax on the gain to help fund the Affordable Care Act and, depending on the state in which the relinquished property is located, state tax in the range of 0 percent to 13.3 percent.
This heavy tax burden often causes an investor to think twice about selling a property and, instead, to retain the asset longer than they otherwise may have. Fortunately, there is a provision in the tax code that allows a seller to defer the tax on this gain by rolling the sales proceeds into the purchase of a replacement property. This is allowed under Section 1031 of the U.S. Tax Code and is commonly referred to as a 1031 exchange, a “like-kind” exchange, or a tax-deferred exchange.
Aside from the primary benefit of tax savings, there are additional benefits to completing a 1031 exchange:
- Investors can trade up for higher-value properties or multiple properties that better match their investment objectives. This most often means newer properties that require smaller maintenance budgets.
- Investors can gain exposure to new markets. This could simply mean changing neighborhoods within a broader market or finding different markets with higher growth potential.
- By crossing state lines and purchasing the replacement property in a more tax-friendly state, an investor can reduce or sometimes eliminate state capital gains tax.
- With the purchase of a replacement property, investors reset their depreciation clock. This means that the 27.5-year residential depreciation timeline restarts and helps save taxes over the life of the new investment.
- Since there is no limit on the number of 1031 exchanges investors can complete, the process allows them to trade up repeatedly and build significant wealth over time.
While the benefits of doing tax-deferred exchanges are many, one must follow strict IRS guidelines to complete an exchange. The most significant of these is that the exchange must meet the IRS definition of “like-kind.” This means exchanging an investment property for an investment property; an investment property for a partnership interest does not meet this definition. The seller of a property must have previously owned the title of the relinquished property and must take the title to the replacement property, as well as ownership in the debt of the asset.
Additionally, there is a short timeline. The replacement property(ies) must be identified within 45 days following the sale of a relinquished property and purchased within 180 days. Next, the value of the replacement property must be equal to or greater than the value of the relinquished property, and the new debt must be equal to or greater than that of the relinquished property. Finally, if there is any cash remaining after the replacement property is purchased, referred to as “boot,” it is taxed at the applicable capital gains rate.
While we do not seek 1031 exchange money from outside investors, Timberland Partners often utilizes this tax strategy to meet its objectives of creating value and building long-term wealth for its investment partners—we understand the value of compounding. When it is time for a partnership to sell a property, we look to defer the taxes and maximize the amount of proceeds available to invest in higher-quality real estate. The 1031 exchange provides more purchasing power as we carefully choose assets with the potential to create additional value for our investment partners.
