News

Rental Market Information Center

Are You Using the 1031 Exchange Tax Shelter?

Landlords, perhaps you have heard of the 1031 Exchange. Today we are going to explain the benefits and how easy it is to save thousands by utilizing it. If you are planning on selling an investment property and you plan to use those proceeds to buy another investment property – you NEED to use the 1031 Exchange. Let us show you why.

What is a 1031 Exchange?

The 1031 Exchange is a section of the Internal Revenue Code that allows an investor to sell their properties and then exchange them for another like-kind investment. When the properties are sold and bought within the 1031 Exchange, all capital gains taxes are deferred until a property leaves the program. This is an awesome way for investors to save tens of thousands of dollars of unnecessary tax liability.

What is a Like-Kind Exchange?

The IRS mandates that a property must be of “like-kind” to qualify for the exchange. The great part here is that based on their definition of like-kind, almost any investment property qualifies. The definition is extremely broad. Your investment property qualifies as a like-kind exchange as long as it is not a personal residence and it is located within the United States or a U.S. territory.

That means that you could sell 15 rental houses and exchange it for a single storefront. You could exchange a mini-storage warehouse for a 25 unit apartment building. You could sell a large developmental property and use the 1031 Exchange to buy an office building. The possibilities are endless.

The Benefits of Using a 1031 Exchange

The primary reason investors utilize the 1031 Exchange is to defer the payment of taxes. As long as the property remains within a 1031 property, there are three specific taxes that you will not owe if you “exchange” the property for another.

Depreciation Recapture Tax

Depreciation expenses are a major tax break for real estate investments. As the years add up, so does the aggregate depreciation deduction. As a result, when you sell your investment property, the IRS claims that you are now financially benefiting from that write-off and they want a large portion of that deduction back. We are talking about 25 percent of the total deduction over the holding period. A 1031 Exchange eliminates that liability.

Federal and State Capital Gains Tax

Taxes on capital gains can significantly cut into the profit an investor receives from a sale of their property. For example, the federal capital gains tax rate is 15 percent. Basically Uncle Sam wants 15% of the money you made off the sale. If your investment property is located in a state that also has a tax on capital gains, then they will want a share too. The capital gains tax is based on the sales price less closing costs and the cost basis. The cost basis is based on the purchase price plus any capital improvements less the total claimed depreciation and closing costs. This can add up to a significant tax burden.

Estate Tax

If the total value of the estate exceeds $5,450,000 in 2016, the heirs are liable to pay the Federal Estate Tax. The estate is valued based on the market value at the time of death or transfer. Properties that are bequeathed within a 1031 Exchange have a stepped-up basis. When the property is inherited, however, the basis value switches from the original purchase price to the current market value. This can effectively eliminate any tax liability.

Check out how placing your properties within a 1031 Exchange will save you thousands. In this example, we will assume that you purchased a 10 unit apartment building ten years ago and made $10,000 of capital improvements. You sold it this year for $400,000. Here is what will happen without your property being part of a 1031 Exchange.

 

Using a 1031 Exchange will save you over $41,000 in unnecessary taxes. I am sure that you could use that money to reinvest into your next property. In our next article, we will show you how to utilize a 1031 Exchange when you sell your investment real estate.

Leave a Reply

%d bloggers like this: