Tuesday, February 24, 2009

1031 Tax Free Exchange - What is it?

1031 Tax Free Exchanges for real property are popular and going to become more popular. [Note: you can do a 1031 Tax Free Exchange for personal property, but it's uncommon as person property (typically equipment of some type) tends to depreciate, as where real property tends to appreciate.] Tax Free Exchanges as a concept isn't difficult, but it is tedious. And as not to confuse anyone, 1031 Tax Free Exchanges are also called "like-kind" exchanges.

If you're reading this, there are a few basics I want to get straight. The 1031 in a "1031 Tax Free Exchange" refers to Section 1031 of the Internal Revenue Code. The statue isn't long and you should take the time to read it if you're thinking about utilizing it. And lets also get the sub-title right, 1031 isn't as much as a Tax Free Exchange as much as it is a Tax Deferment Exchange. Let me explain;

If you're thinking about completing a 1031 Tax Free Exchange, then you're concerned about paying taxes on capital gains, which are currently taxed at a rate of 15%. A quick and simple definition of capital gains on real property is the amount of profit you make on it's sale. For example, you buy a commercial lot for $200,000 and sell it for $250,000, then you've made a profit [or capital gains] of $50,000. The IRS will be expecting you to pay a 15% capital gains tax on your profit, or $7,500.

For another example, imagine you're a farmer with a 100 acre farm on the edge of Leander. In 1979 you purchased your farm for $800 an acre, or $80,000. Today (2009) you just received an offer from a corporate home builder to purchase your farm for $40,800 an acre, or $4,080,000. Smile, your ship has just come in, and no doubt the commercial real estate broker you enlisted to sell your beloved farm has served you well. Now frown, because your accountant has just reminded you that you will now need to pay a 15% capital gains tax on your $4,000,000 profit, or $600,000. That's no fun.

Additionally, keep in mind that historically, the Capital Gains Tax rate has been higher than 15% and many political pundits expect it to rise above it's current rate in the near future (20%?).

How can a 1031 Tax Free Exchange help you? Section 1031 of the Internal Revenue Code allows you to take your profits [or capital gains] and purchase "replacement" real property. Once you do this correctly, the IRS will not require you to pay capital gains taxes on the sale proceeds.

But please note, the tax burden hasn't gone away, it's just been postponed. When you sale the replacement property or say, your relatives inherit the replacement property, the capital gains burden reappears. That's why I think calling it a Tax Deferment Exchange is a better definition, but regardless what it's called, you're not paying the taxes now, which can be extremely helpful by keeping your money in your pocket and increasing your ability to buy real property. [Before you ask, yes. Yes you can 1031 the proceeds from the sale of replacement property, into new replacemet property, with a caveat or two.]

When counseling with my clients, I ofter ask them what they want to do with the sale proceeds. That's an important question and depending on the answer I at times recommend a 1031 Tax Free Exchange, but often I recommend paying the capital gains tax and putting the money in the bank. As I stated earlier, the current 15% capital gains tax rate might be the lowest it will be for some time.

My next blog I will go into the how, when and where we get an exchange completed.

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