Tag Archives: real estate exchange

Why Do a 1031 Exchange in a Down Real Estate Market?

Should you consider a 1031 exchange in a down real estate market?

In the booming real estate market of a few years ago, property owners saw their real estate assets increase dramatically in value.  As a result, if they sold their property they would have significant capital gains and therefore owe significant capital gains taxes that could be deferred or eliminated by a 1031 exchange.

Such dramatic increases in value are much less common in our current real estate market.  In fact, many properties have decreased in value, and would not lead to significant capital gains taxes if sold.

The question then is: if your property has not significantly appreciated in value, and you will not have a significant capital gain if the property is sold, is there still a reason to do a 1031 exchange?

The answer is yes.

Most people think of 1031 exchanges only in regard to avoiding capital gains taxes.  That’s only half the story.

In almost all real estate transactions, capital gains taxation has two components – taxes on actual gain and recapture of depreciation. The depreciation recapture provisions of Section 1250 (real property) and Section 1245 (personal property) apply to Section 1031 exchanges as well as sales. These provisions require depreciation to be recaptured at the higher ordinary income rate (instead of the long-term capital gain rate) when the property is sold or exchanged and a gain is recognized.

On the other hand, if you exchange property that is subject to recapture and no gain is recognized, the recapture potential of the relinquished property is not paid by you, but instead, carries over to the replacement property.

Moreover, this recapture potential can be deferred endlessly if you continue to transfer the property through Section 1031exchanges.

Thus, from a dollar perspective, avoiding the recapture of depreciation is just as important – and often more important – than avoiding taxes on actual capital gain since the monetary amount demanded by the government as recapture of depreciation is often larger than the taxes on actual capital gain.

In order to properly understand how recapture of depreciation works, you must first understand depreciation, and especially how the government looks at depreciation.

Simply stated, depreciation is loss of value. Over time all property except unimproved land depreciates, in the sense that over time all property except unimproved land undergoes wear and tear, becomes obsolete, and loses some of its physical integrity as foundations settle, damage is caused by long term exposure to air, water, and insects, and materials such as wood, metal, and concrete deteriorate.

The tax code properly recognizes this natural loss of value over time and allows property owners to deduct a prorated portion of this natural and inevitable loss of value each year from the owner’s basis in the property.

Deductions based on depreciation are taken according to schedules established by the IRS. For residential real estate and improvements, depreciation is taken over 27 years (known as the recovery period). For all other real property, including nonresidential investment property, depreciation is taken over a recovery period of 31 years.

While different kinds of assets are depreciated by different methods, all real properties, including buildings and permanent improvements, are currently depreciated using the straight-line depreciation method. Under the straight-line depreciation method, an identical proportional amount is deducted from your taxes as depreciation each year over the entire recovery period.

Crucially, because depreciation reduces your adjusted basis in a property, it has the effect of increasing the amount of profit – or, more precisely, the amount of capital gains that the IRS insists that you pay tax on when you sell the property.

The longer you’ve owned a particular property, the more depreciation has been taken and the lower your adjusted basis. Thus, the longer you own a particular property, the more depreciation will increase the amount of taxable capital gain, even without any cash profit due to appreciation.

For example, let’s say that you purchased a property 20 years ago for $400,000 and sell it today for exactly the same amount. You have absolutely no profit due to appreciation. But because of the depreciation allowable over the 20 years that you have owned the property, you will still have a taxable capital gain of approximately $300,000, even though you will have no cash profit whatsoever.

Even more significantly, even though you have no cash profit, you would still owe the government capital gains taxes of approximately $45,000!

Using a Section 1031 exchange allows you to legally avoid paying this tax, and instead, legally keep the money that you have deducted from your taxes as depreciation over the time that you’ve owned the property.

It is also important to note that the scheduled deductions for depreciation (and the resulting decrease in your property’s basis) are built into the tax code and are not at the discretion of the taxpayer. In other words, you cannot choose whether to depreciate your property and, hence, decrease your basis.

Even more significantly, you cannot claim an exemption from the recapture of depreciation because you did not, in fact, take the deductions due to depreciation that you were entitled to.

The government simply and absolutely assumes that you have taken all scheduled depreciation deductions, regardless of whether you have actually taken the depreciation deductions or not, and will insist that this allowable depreciation be “recaptured” when the property is sold.

So the answer to the question “Should I consider a 1031 exchange in a down real estate market?” depends not only on your actual capital gains, but also whether you want to avoid paying the government the amount of depreciation that the property has been entitled to during the time you have owned it.

In many cases, the answer will be yes.

For more information on this topic, and for everything you need to know about 1031 exchanges, see our book 1031 Exchanges Made Simple, available at Amazon.com.

To contact Melissa J. Fox about serving as a qualified intermediary or for other 1031 exchange services, send an email to strategicfox@gmail.com

1031 Exchange Q and A: Can You Exchange a Vacation Home in Taos for a Casa in Mexico?

Sabina and Jeremy live in Houston, Texas, and own a vacation home in Taos, New Mexico, where they have enjoyed vacations. When they bought the vacation home six years ago, they thought that they would rent it to other vacationers when they weren’t using it and allocate the rental money they received to pay the mortgage on the property.

After two seasons as landlords, Sabina and Jeremy decided that they didn’t need the extra headaches that seemed unavoidable in renting the house and dealing with tenant demands, complaints, and damage to their property. For the past four years, they have kept the property solely for their own use, except for occasional uses by close friends and relatives.

Now Sabina and Jeremy think that this would be a good time to cash in on the rise in property values in Taos over the last six years. When they bought the house, they paid $125,000. In today’s market, it’s worth $725,000. Jeremy knows someone who owns a dream house on the beach in Mexico and who would be willing to do a Section 1031 exchange for their vacation property in Taos.

Jeremy thinks that a Section 1031 exchange would be a great way to legally avoid paying capital gains taxes of about $90,000 that they would owe the government if they let go of the vacation home through a sale.

Is Jeremy overlooking anything important?

What should Jeremy and Sabina do?

Jeremy has indeed overlooked some very important limitations on the kinds of property that qualify for a Section 1031 exchange.

For property to qualify for a Section 1031 exchange, the property must be “held for productive use in a trade or business or for investment.” In the past, the IRS had ruled that this requirement excluded vacation homes from 1031 exchanges.

Recently, however, the IRS has declared that that property that is rented to others but also occasionally used by the owners for personal purposes (such as vacation homes) may be exchanged under Section 1031 when (1) the property has been owned by the taxpayer for at least 24 months immediately before the exchange, and (2) the period of the taxpayer’s personal use of the property does not exceed the greater of 14 days or 10 percent of the number of days that the dwelling is rented at fair market value.

Sabina and Jeremy’s vacation home in Taos meets the first requirement — that is, they have owned it for at least 24 months — but does not meet the second requirement — because their personal use of the property exceeds the greater of 14 days or 10 percent of the number of days that it is rented at fair market value.

In order for Sabina and Jeremy to do a Section 1031 exchange with their Taos vacation property, they would first need to recharacterize the property for taxes purposes as property “held for productive use in a trade or business or for investment.”

They could do this by again renting it to vacationers. The date the IRS uses to determine whether property has been held for a qualifying business use is the date of the transaction; any previous use is theoretically irrelevant.

But while there is no clear rule regarding a “holding period” in order to recharacterize property as held for productive use in a trade or business or for investment, most tax advisors recommend a period of one to two years (in no case less than 12 months) in the new use, to be able to report rental income and deduct depreciation and other business expenses regarding the property on your tax returns for that period of time.

Or, under the new IRS ruling on 1031 exchanges and vacation homes, Sabina and Jeremy could discontinue their own use of the propery entirely — so that their personal use is less than the greater of 14 days or 10 percent of the number of days that the dwelling is rented at fair market value.

In addition, Jeremy has overlooked the geographic limitation on property that qualifies for a Section 1031 exchange.

While the IRS interprets the “like-kind” requirement under Section 1031 very broadly (all real property located in the United States is considered “like-kind” to all other real property located in the United States), the property must be located in the United States.

Foreign property (for example, the property in Mexico that Jeremy is interested in obtaining), or even in overseas U.S. possessions such as Guam and Puerto Rico, is not considered “like-kind” to any property located in the United States and is not qualified for exchange under Section 1031.

While Sabina and Jeremy can, under certain circumstances, do a 1031 exchange with their Taos vacation home, they can not trade it for una casa en la playa en México.

To contact Melissa J. Fox about serving as a qualified intermediary or for other 1031 exchange services, send an email to strategicfox@gmail.com

Why Use a 1031 Exchange?

There are many things you can do with your real property – from keeping it to selling it to giving it away to family members or charity.

Each of these choices has predictable financial, legal, and other consequences, and wise real property transactions are made with a full awareness of, and appreciation for, all of these consequences – especially the tax consequences.

The sale of real estate is a taxable event, and all profit from the sale of real estate is taxed as capital gains in the year of the sale. If you sell a property that has appreciated in value, you will be required, in general, to pay capital gains taxes on the difference between what the property cost you and what you get for it now, plus recapture of any depreciation you have previously taken. If your property has substantially appreciated in market value, you will be required to pay a substantial amount of money as capital gains taxes and depreciation recapture to the government.

A Section 1031 exchange allows you to legally avoid paying these taxes.

Section 1031 (a)(1) of the Internal Revenue Code states that “No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment, if such property is exchanged solely for property of like-kind which is to be held either for productive use in a trade or business or for investment.”

What this section means is that Section 1031 exchanges – if done properly – have the special benefit, unlike other forms of real property transactions, of allowing the complete legal avoidance of capital gains taxes and recapture of depreciation.

Technically, a Section 1031 exchange is a tax deferral rather than a tax elimination technique. The new replacement property purchased with the proceeds from the sale of old relinquished property has the same tax basis as the old property, and when the new property is later sold, the deferred capital gain, plus any additional gain realized since the purchase of the new property, is subject to taxation.

But since you can continue to exchange the new properties you obtain through Section 1031 exchanges again and again, you can continue indefinitely to legally defer taxes.

In other words, by taking advantage of the full benefits of the Section 1031 exchange process, you never have to pay taxes on the transfer of real property. Upon death, the basis of property gets “stepped-up” to its fair market value and the accumulated capital gain is never taxed. Even those who inherit the property can sell it at its fair market value at the date of death and not pay tax on that gain.

As Section 1031 exchangers like to say, you can “swap ’till you drop.”

You don’t have to be a financial genius to recognize that avoiding tax liability is always a good investment practice. If you can defer payment of taxes to some indefinite date in the future, you will have more money to invest today.

By putting the money that you save in taxes today to work for you now in sound real estate investments, you will have more equity in the future. By properly using the tax avoidance strategy of Section 1031 exchanges, with the money you save by legally avoiding capital gains taxes and depreciation recapture, you are able to continually step up your real estate portfolio and build substantial wealth from your original investment.

To contact Melissa J. Fox about serving as a qualified intermediary or for other 1031 exchange services, send an email to strategicfox@gmail.com