Delay taxes on appreciated investment property or business assets
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Many of our clients own business assets or personal property that have appreciated in value and struggle with ways to sell these assets without triggering immediate capital gains taxes. The good news is, there is a way to defer these taxes by using a 1031 Exchange.
If you’ve ever owned real estate for business purposes or physical property as an investment, you’re probably well aware that these assets can leave you susceptible to large capital gains taxes as they appreciate in value.
Perhaps you own an apartment building and rent out the units for additional income, maybe you own a plot of land, or even valuable artwork. Whenever you sell these items, like any taxable investment, you could be subjected to capital gains taxes for any appreciation above your original cost basis. However, if your intent is to sell your property and exchange it for a similar replacement, the IRS allows for the delay in recognizing any capital gains given certain parameters are met. Known as a “1031 Exchange,” the Internal Revenue Code allows for a “like-kind” exchange of properties to delay recognition of any capital gains taxes if the property is held either for investment or as a business asset.
Example A: Sell property
As an example, if you had purchased a rental property for $300,000 ten years ago and today it is worth $500,000, you would be responsible for $200,000 in capital gains taxes if you sold it outright.
Example B: Exchange property
However, if you instead exchanged the property for another rental property, the IRS would allow you to delay paying taxes on the $200,000 appreciation until you subsequently sell the new property. Doing so could push a potentially large tax burden off until a more favorable time for you.
Example C: Exchange property with "boot"
A caveat to this rule would be if there was an exchange of additional cash, additional property value such that the exchange were of unequal worth, or debts passed between parties. The amount of this unequal exchange is known as “boot.” In our previous example, consider if there was an outstanding mortgage of $100,000 on the property that you had exchanged. In this case, the IRS considers the exchange of the mortgage as an additional credit to you (known as “receiving boot”) thereby reducing the amount of capital gains you can delay. You would thus be responsible for paying $100,000 in capital gains but still be allowed to delay the remaining $100,000.
1031 Exchange nuances
While a 1031 Exchange can be very useful, it is not without its rules, restrictions, and tax pitfalls. As such, this type of maneuvering should only be undertaken with the close guidance of your tax preparer or accountant.
One notable aspect is the strict interpretation of which assets are not afforded this treatment. 1031 Exchanges are not permitted for personal-use assets (such as an automobile), inventory, securities (stocks and bonds), an exchange of foreign real estate for domestic real estate, and partnership interests, just to name a few.
Alternatively, the IRS has a fairly loose interpretation of what represents a “like-kind” property. According to the IRS, the exchange must be of properties that are similar enough, matching in nature, class, and/or character. You can also take advantage of the "exchange period" if you haven't selected a replacement property at the time of sale. During this period, you have 45 days to identify the new property and 180 days to complete the purchase.
This combination of strict guidelines and loose interpretations makes it all the more important to work closely with your accountant and tax preparer to maintain accurate records of your cost basis (including any adjustments) while staying within the bounds of the law.
In partnership with your accountant, your Mesirow wealth advisor can talk with you about whether this type of exchange might make sense for your unique situation.
Kaplan University – CFP Exam Curriculum 2016. Course 104. Unit 8, Pages 133-136