Pursuant to Internal Revenue Code section 1031, taxpayers are allowed to defer the gains realized on sales or exchanges of real property if the exchange meets the requirements of the provision. These benefits will be allowed only to real property held for productive use in trade or business or for investment if the properties subject to the exchange are also of “like-kind” by their nature. In order to understand the benefits of a like-kind exchange (or “1031 exchange”), a taxpayer should have a fundamental understanding on basis because basis management is a fundamental component in like-kind exchange planning.
Basis is the amount of a person’s investment in a particular asset. The types of assets that are subject to basis calculations include real estate, securities, intangible assets, and tangible assets ranging from inventory to physical possessions. Depending on the type of asset in question, there are numerous factors that can affect the value of its basis. As a starting point, the first factor under consideration is the amount the person paid to acquire a particular asset. This is otherwise known as the cost basis of an asset. Generally, costs that are associated with a purchase, such as legal fees, commissions, closing costs and taxes, are adjusted to increase the basis of the asset.
Since this article primarily focuses on the basis of real property, other factors that can affect the adjusted basis of real estate assets include improvements and depreciation. Adjusted basis can be calculated by the cost basis of the asset increased by any improvements less any depreciation deductions that may or may not have been taken throughout the course of the useful life of the asset. Improvements, such as new construction of a guesthouse, are additions to the property that did not exist before, which thereby increase the adjusted basis of the asset. However, mere repairs such as remodeling of a bathroom are not deemed improvements and consequently do not increase the basis of that asset.
Total Cost of Acquisition: $100,000
Adjusted Basis: 100,000 + 80,000 – 30,000 = $150,000
Depreciation deductions are taken throughout the course of the useful life of an asset for the normal wear and tear of that asset. Depending on the class of asset, depreciation deductions are calculated by the percentage of the asset’s value spread over a number of years. For example, the useful life of a laptop computer is between four to five years.
For primary residences, the useful life is 27.5 years, whereas for commercial real estate it is 39 years. Note, however, depreciation deductions cannot be taken on the land itself because land cannot theoretically lose its useful purpose, but the deductions can be taken on the structure on which the land is situated.
Capital Gains and Losses
Capital gains and losses are determined by the difference between the amount realized on the sale of the asset and its adjusted basis. Thus, if the property with the adjusted basis of $100,000 was sold for $200,000, there would be a $100,000 capital gain on that transaction. If the sale results in a capital loss, individual taxpayers can deduct from their income taxes within certain limits during the tax year in which the transaction occurred. The remaining losses can be carried over to subsequent years.
Capital gain rates may vary depending on how long the property was held for and the taxable income of the individual. If the asset is held for more than one year, it will be taxed at the long-term capital gain rates which are more favorable than short-term (assets held for less than one year) capital gain rates because short-term capital gain rates are generally taxed at the ordinary income level. As of 2020, the maximum capital gain rates are at 20%, whereas the maximum ordinary rates are at 37%.
The three levels of capital gain tax rates are at 0%, 15%, and 20%. Generally, long-term capital gain rates do not exceed 15% for most individuals. The following example contains figures from a single individual who realized a gain on an asset between the time of purchase and its sale.
May 2017: Investment property purchased
Adjusted Basis: $250,000
June 2020: Investment property sold
Fair Market Value: $350,000
Taxed at 15% because asset held for more than one year and the total income is less than $434,550
Tax owed: 15% of 100,000, or $15,000
It is important to note that the capital gain rates may not necessarily apply to the entire gain realized from the sale. Any depreciation deductions that were subject to be taken may be recaptured under the 25% rate or at the ordinary income rate for non-real estate property even if the depreciation deductions were not taken. There may also be net investment income tax of 3.8% added if an individual’s taxable income exceeds $200,000 ($250,000 for MFJ).
For residential real estate, up to $250,000 ($500,000 for MFJ) of gain can be excluded so long as the property is designated as a primary residence during the two of the preceding five years prior to the sale. The taxpayer must have also not excluded gains from the sale of a primary residence in the two years prior to the sale. Thus, if the difference between a single filing taxpayer’s adjusted basis in the property and the amount realized is less than $250,000, she will not owe capital gain taxes from the sale.
Single taxpayer sells qualified primary residence after 4 years
Adjusted Basis: $375,000
Amount Realized: $575,000
Realized Gain: $575,000 – $375,000 = $200,000
No capital gain tax because total gain is less than $250,000 and holding period satisfied
Basis Upon Gifting
The basis of gifted property is the adjusted basis of the person gifting the property. This concept is otherwise known as “carry-over basis” because the basis of the person gifting the property (the “transferor”) carries over to the person receiving the property (the “transferee”).
Greta transfers her interest in an office building to her grandson, Sam, during her lifetime
Greta’s Adjusted Basis: $350,000
Fair Market Value at the time of transfer: $1,000,000
Sam’s Adjusted Basis (carried over): $350,000
As of date of transfer, Sam’s capital gain: $650,000
If Sam sells now, tax owed: 20% of $650,000, or $130,000
Basis Upon Inheritance
The basis of inherited property is generally the fair market value of the property on the date of the decedent’s death. If the property has appreciated in value between the time of acquisition and the decedent’s death, the basis the heir inherits “steps up” in value; or conversely “steps down” if it has depreciated in value.
Sam inherits Greta’s personal residence after her death
Greta’s Adjusted Basis: $450,000
Fair Market Value at the time of Greta’s death: $1,000,000
Sam’s Adjusted Basis (stepped up): $1,000,000
As of Greta’s death, Sam’s capital gain: $0
If Sam sells now, tax owed: $0
Why Wait to “Step-Up”
While a carry-over transfer of an asset may be the easier approach, it can potentially be the more expensive one down the road. Granted that transfers of assets after death may entail more procedural hurdles such as probate or trust administrations, the tax savings under a step-up in basis especially in the context of real estate can be monumental. The step-up tool allows for the taxpayer to potentially pass on far greater wealth to her heirs than she otherwise would have if she transferred her assets during her lifetime.
Under IRC section 1031, no gain or loss is recognized on an exchange of real property held for productive use in trade or business or for investment when it is exchanged solely for real property which is also to be held for productive use in trade or business or for investment. Properties are deemed to be of like-kind if they are of the same nature or character. The scope of permissible exchanges range from improved property to vacant lots and farms.
Process of the Exchange
When the taxpayer puts forth his qualified property into the exchange, he is deemed to be relinquishing it. When the taxpayer is acquiring the qualified property, he is deemed to be replacing his relinquished property. This is why the property the taxpayer is relinquishing is classified as the “relinquished” property and the property the taxpayer will be receiving after the exchange is complete is classified as the “replacement” property.
Under the statutory guidelines, the taxpayer has 45 days to identify the replacement property from the date the taxpayer transfers the relinquished property to a third-party such as a qualified intermediary. The taxpayer will then be subject to complete the exchange at the earlier of when his taxes are due or 180 days after the date of transfer of the relinquished property.
The taxpayer can engage in a direct swap with a property of like-kind. For example, Tony can exchange his condominium with Susan’s farm. Tony can also exercise the three-property rule or the 200% rule within the 45-day identification period. Under the three-property rule, Tony can identify three properties of any value and satisfy the identification requirement. Tony can also satisfy the identification requirement by designating any number of properties so long as their aggregate amount does not exceed 200% of the fair market value of the relinquished property.
Prior to facilitating the exchange, the taxpayer must have the proper intent of use on the relinquished property. Generally, a two-year safe harbor period whereby the taxpayer holds the property for qualified use such as for investment purposes satisfies this requirement. The taxpayer must also hold the replacement property for qualified purpose for a two-year period after acquiring it.
Boot is any non-like kind property that is received as part of the exchange. This includes cash, assumption of liabilities, or other property. Any gains from the boot will be recognized at the taxpayer’s expense and subject to current income taxes even though losses would not be recognized. As a rule of thumb, if the market value of the property purchased is equal or greater to the property that is sold, boot will not be triggered. On the other hand, if it is sold for less, taxes would be owed to the extent of the boot.
Amount of relinquished property: $1,000,000
Amount of replacement property: $800,000
Taxable boot: $200,000
Indefinite Deferral, Step-Up at Death
The gains on the exchanges are deferred to a later time, possibly never. Deferral generally means that taxes are paid at a future date instead of the period in which they are incurred. If the property is sold prior to the taxpayer’s death, all the gains that can be traced to the original exchange will be taxed. Note that there will also be a recapture on depreciation deductions on properties placed in service after 1985 even if the deductions were not taken. The portion of the un-recaptured gain may be taxed at the higher rate of 25% even though the highest capital gain rate is currently at 20%.
1988: Property 1 purchased by Investor for $85,000
1988 – 1994: Depreciation Deductions taken = $20,000
Adjusted Basis (AB) as of 1994 = $65,000
1995: Property 1 appreciates to $230,000
Property 1 exchanged for Property 2 valued at $240,000
AB: $65,000 + $10,000 ($240,000 – $230,000) = $75,000
1995 – 2002: Depreciation Deductions of $50,000 are not taken
AB as of 2002 = $15,000 (Note: even though DD were not taken)
2003: Property 2 appreciates to $400,000
Property 2 exchanged for Property 3 valued at $450,000
AB: $15,000 + $50,000 ($450,000 – $400,000) = $65,000
2003 – 2005: Depreciation Deductions taken = $30,000
2006: Property 3 appreciates to $475,000, Investor sells
Basis before Depreciation: $145,000 (85,000 + 10,000 + 50,000)
Total Gain: $330,000 (475,000 – 145,000)
Total Depreciation: $100,000 ($20,000 + $50,000 + $30,000)
Capital Gain: $46,000 or 20% of $230,000 ($330,000 – $100,000)
* Assuming highest tax bracket
Depreciation Recapture: $25,000 or 25% of $100,000
* Assuming straight-line method used
Total Tax: $71,000 ($46,000 + $25,000)
The taxpayer can potentially engage in an unlimited number of deferred exchanges during the course of his lifetime. At his death, the last property subject to the exchange will receive a step-up in basis. Consequently, the taxpayer’s heirs will inherit the fair market value of the last property subject to the exchange as the new basis in the property and the gains that were previously deferred would not affect the heirs if they sold the property upon inheriting it. This does not mean that the heirs should necessarily sell the property immediately upon inheriting it, but the adjusted basis in the property can significantly increase and in the event of a sale at a future date, the capital gain taxes can be nominal.
Example 8 has the same facts as Example 7 until 2006
2006: Property 3 appreciates to $475,000, Investor dies, Heir sells (step-up)
Capital Gain: $475,000 – $475,000 = $0
Depreciation Recapture: $0
Total Tax: $0
Why Planning Matters!
Tax planning is an essential tool in maximizing one’s wealth, whether it pertains to annual income taxes, investment decisions, or business operations. Through proper estate planning, a person can also potentially pass on even greater wealth to future generations. The art of maximizing one’s wealth is as much of an art as generating that wealth.
Have a question on 1031 Exchanges or your estate planning? Contact Haik Chilingaryan.