By Sharon Thompson, EdM. M.A., KW Commercial Indiana
While preparing April taxes, many individuals and companies begin discussing future real estate transactions. One important real estate planning tool still currently available is IRC Section 1031 for Tax Deferred Like Kind Exchanges. Through a 1031 Tax Deferred Like Kind Exchange, taxes from the sale of an investment property are deferred into the future with the acquisition of the next investment property. Instead of potentially paying up to 40% of gains/equity to taxes, individuals are able to re-invest nearly 100% of the sale proceeds into a new investment, provided they meet strict requirements and timelines on this process.
What is a 1031 Tax Deferred Like Kind Exchange?
IRC Section 1031 allows investors to sell one or more appreciated real estate assets and defer the payment of capital gains tax by acquiring one or more like-kind replacement properties. Like-kind is defined as any real property held for investment or real property used in a trade.
Here are common types of investment properties that can be used as Like-Kind Properties:
- Single Family Residential Properties (excluding personal residences)
- Multi Family and Apartments
- Commercial Offices
- Industrial Warehouses
- NNN Leases
- Vacant Land
- Income Producing Vacation Rentals
- Mineral or water rights
- Delaware Statutory Trusts (DST) Investment Property Interests.
Like-Kind Properties do NOT include selling your primary residence, your second home or vacation home as well as partnership or membership interests.
Who Could Benefit from a 1031 Tax Deferred Like Kind Exchange?
Many individuals own highly appreciated commercial real estate personally or through the businesses they control. A significant number of these individuals also have a very low basis in these properties. As a result, individuals that consider selling these properties or businesses will likely face significant capital gains and depreciation recapture taxes that can erode the amount of capital they have to reinvest or pass along to their heirs.
Benefits and risks for an exchange vary by seller and decisions should always be based on the advice of your accounting or tax professional.
Owners that choose to sell highly appreciated real estate assets in a 1031 Exchange often seek these tax deferral objectives:
- Federal capital gains (20.0% / 15.0%)
- State capital gains (0.0% – 13.3%) Indiana’s current rate is 3.3% plus applicable county rate
- Medicare surtax on net investment income (3.8%)
- Depreciation recapture (25.0%)
Property owners may also seek objectives to fit current financial and personal goals. Common reasons for exchanges include: Stable current income, limiting leverage, decreasing burden and time commitment of managing real estate, diversification of real estate by geographic location or asset class, higher or institutional quality real estate and to facilitate estate planning.
Delaware Statutory Trusts (DSTs) have grown in interest recently. DSTs offer an intriguing option for investors who are looking for properties to complete their 1031 Exchanges. A DST is an “arm chair” investment”, or a passive investment opportunity that allows individuals to own fractional shares in institutional grade properties.
A REAL ESTATE SALE EXAMPLE
An investment property owner sells a rental property for $400,000. The owner originally purchased the property for $200,000. There is $200,000 of debt and the property has been fully depreciated. The capital gain is approximately $350,000 (assuming 75% of the property is depreciable).
If the investor does not do an exchange, federal capital gain taxes would be:
|$150,000 (depreciation recapture) x 25% =||$37,500|
|$200,000 (capital gain balance) x 15% =||$30,000|
|$350,000 Capital Gain||Taxes Owed||$67,500|
The state taxes owed (where applicable) would need to be added to the federal taxes due. In Indiana county taxes may also apply. Assuming the property owner sold in Indiana, the following additional taxes would need to be paid:
|State level (IN) 3.3%, $350,000 x 3.3%=||$11,550 + County Tax|
|Total Capital Gain Taxes Fed. & State||$79,050 + County Tax|
A REAL ESTATE SALE VS. A 1031 TAX EXCHANGE
This comparison analyzes the value of the new property that could be acquired in a sale versus an exchange. This comparison assumes an owner makes a 25% down payment and finances 75% of the property (75% loan-to-value ratio).
|Equity||$200, 000||$200, 000|
|Total Capital Gain Taxes||$79,050||$0|
|Cash to Reinvest||$120,950||$200, 000|
|New Property||$483,800||$800, 000 ASSUMING A 75% LOAN-TO-VALUE|
So as you look at your taxes and plan your future real estate transactions, maybe you should calculate if this may be a tool for you or someone you know.
More Information is available from Sharon Thompson, EdM, MA, Executive Director of KW Commercial for Keller Williams Indianapolis Metro Northeast and Registered Representative of Silver Portal Capital. Silver Portal Capital is an investment and merchant banking boutique focused exclusively on the real estate sector. Silver Portal works with some of the leading sponsors of DSTs in the country.