28
July
2016

The Tax Man Cometh: Deferring Taxation With a 1031 Exchange, Part 3

In Part One and Part Two of our blog series on 1031 exchanges, we’ve covered the basics of how a like-kind exchange works and the specific rules and regulations you must adhere to in order to execute a successful transaction. But what about the long-term impact of this tax-deferral method?

Every shrewd investor is looking to minimize the amount of their return that they have to give up to Uncle Sam, but legally avoiding taxation is a very tricky business. Because tax revenue is require to fund important infrastructure projects – like building schools and maintaining roads – avoiding your tax bill altogether is typically not possible. The truth is, there is not supposed to be a way to fully avoid paying taxes on your capital gains – a 1031 exchange is not meant to eradicate your tax burden, simply to defer it. However, while the federal government may have created the 1031 exchange procedure as a temporary deferral mechanism, there may still be ways for you to permanently (and legally) defer taxation with a little legwork and some solid planning.

We will look at what you can do to eliminate capital gains taxes on your successful REI investments in our next two posts. But first, let’s use this third installment to dissect and discuss the short-term tax impact of a 1031 exchange.

Important Terms

Before we move on, there are a few important terms that we should all get comfortable with. We’ll be referencing these subjects regularly throughout this post, so a firm understanding of their definitions is crucial.

  • Deferral: To delay payment of taxes. While the IRS allows you to delay taxation through a 1031 exchange, the amount that you would owe on your gains is still meant to be collected later, when you sell the new property. We’ll explain how this works later.
  • Capital Gain: The amount of profit you make on the sale of an investment. So if you buy an asset – stocks, bonds, real estate – for $100,000 and then sell it for $150,000, you have $50,000 of capital gain. The tax rate applicable to your capital gains will vary depending on how long you held the investment and other fa
  • Tax Basis: This is the amount of your capital investment in a property. If you buy a home for $250,000 but sell it for $550,000, then your tax basis, or simply ‘basis’, is $250,000 and your net gain is $300,000. In some instances, your tax basis can be different from the asset’s purchase price, as you’ll see below.
  • Adjusted Tax Basis: The tax basis of a property can be increased or decreased as a result of a number of factors, including deferral of gain in a previous 1031 exchange, improvements made to the property, or depreciation costs claimed on your tax return. The adjusted tax basis takes into account all applicable factors, not just the property’s purchase price. This is what is used in calculating your taxable gain when you sell the property.

The Tax Impact of a 1031 Exchange

To understand how to use a 1031 exchange to permanently avoid taxation, you need to understand how they are meant to work.

The IRS created the 1031 exchange process to allow people to defer taxation and use those funds to invest further, stimulating the economy. However, the 1031 exchange process is meant to be, mostly, a one-off thing. You want to buy a new investment property with the proceeds of your sale, so you use the 1031 to defer taxation and put that money toward a bigger investment. However, when you sell your new investment property, the tax man comes a-calling.

Basically, any amount of capital gain you would have paid taxes on in the initial sale is transferred to the new property in the form of a reduced tax basis.

Example

Assume Property A is the property you are selling and Property B is the asset you wish to purchase using a 1031 exchange. For the purposes of this simple example, all purchases are made in cash and it is assumed that there are no property improvements, closing fees, or other variables to consider.

  • Property A Purchase Price: $250,000
  • Property A Sale Price: $550,000
  • Property A Tax Basis: $250,000
  • Property A Capital Gain: $300,000

To calculate the adjusted tax basis for your new property, you simply subtract the capital gains on Property A ($300,000) from the purchase price of your new property.

  • Property B Purchase Price: $600,000
  • Property B Original Tax Basis: $600,000
  • Property B Adjusted Tax Basis: $300,000

Instead of paying capital gains taxes on the profit from the sale of Property A, the amount of your gains is transferred to Property B, reducing your tax basis. So, when you eventually sell Property B, you will essentially owe capital gains tax on the profit from that sale and the profits from the sale of Property A.

  • Property B Sale Price: $1 million
  • Taxable Gain Without 1031: $1 million – $600,000 = $400,000
  • Taxable Gain With 1031: $1 million – $300,000 = $700,000

Notice that the taxable gain on the sale of Property B after purchasing it through a 1031 exchange is the same as the sum of the taxable gain on both Properties A and B if you had not executed an exchange ($300,000 + $400,000 = $700,000). Basically, Uncle Sam lets you run a tab on your capital gains taxes. You still pay the whole bill, just at a later date.

Until Next Time…

Now you understand how a 1031 exchange is supposed to work, which is an important step in minimizing your tax burden. But, since your capital gains tax is only deferred until you sell Property B, how can you use a 1031 exchange to permanently avoid taxation? In our final posts in this series, we’ll discuss two strategies that can enable you to defer taxation permanently, for both you and your heirs.

In the meantime, if you have any questions about 1031 exchanges, turnkey investments, or what we do here at Spartan that sets us apart from the rest, feel free to reach out at any time!

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