The 1031 like kind exchange target persona is an individual or corporation who owns real or personal property held for productive use in a trade, business or investment and subject to US federal and state income taxes. The target market will defer $3.7 billion in federal capital gain taxes in 2013 according to the Joint Committee on Taxation. Do you own land, improved property or tangible and intangible personal property, including aircraft, construction equipment, livestock, gold and silver bullion, collectibles, vintage cars or artwork? When selling, is your intention to replace with another like kind property? If selling real property, like kind means any type of real property, including a lessee’s interest in a thirty year lease. If selling personal property, the replacement personal property must be like kind or like class, as in bull for bull, gelding for a male horse or silver bullion for silver bullion.
Federal and State Capital Gain Tax Deferral
When real or personal property is sold, federal and state capital gains taxes are imposed on the appreciation or when the asset is sold for a higher value than its original purchase price plus capital improvements less depreciation. In addition, a twenty five percent tax is triggered on the aggregate depreciation, taken or not. Depreciation is the allocation of the asset purchase price over the asset’s useful life. The asset owner is allowed to deduct the allocation each year to reduce their income tax. The allocation is dependent upon how the Modified Accelerated Cost Recovery System (MACRS) categorizes the type of asset and useful life. For example, the depreciation of an investment single family rental property is 27.5 years versus 39 years for commercial property. Each year the owner of non-commercial property reports on their federal tax return 1/27.5 of the purchase price plus capital improvements to reduce their income tax. When the property is sold, twenty five percent of the depreciation is taxed in what is recognized as depreciation recapture.
Federal capital gain is either short term or long term. Short term gain is when the asset is held less than a year and is taxed as ordinary income. Long term gain is when the asset is sold after a year or more and is subject to the following tax brackets dependent upon whether filing individually or married Adjusted Gross Income (AGI).
Notice that if the taxpayer’s AGI is below a certain threshold, there is no federal capital gains tax.
State capital gains taxes range from zero to over ten percent. The taxpayer’s resident state determines the state tax, however, if California property owned by a non-resident, is replaced with property in another state, then when sold without initiating another 1031 exchange, the capital gain from the California property is due. See California Assembly Bill 92 effective January 1, 2014.
A number of counties and cities tax capital gain, so be sure to check with your CPA. Add the taxes together and the tax bill can be over 40 percent of the sales price. Federal capital gain on collectibles is 28 percent, plus state and depreciation recapture.
The Treasury Department Regulations and Internal Revenue Code Section 1.1031 allow the taxpayer to defer or postpone payment of these taxes when replacing with like kind property. Rather than pay out the 40 percent, the tax is deferred, effectively providing an indefinite, interest free loan. Taxpayers who own property internationally use 1031 exchanges to defer their federal obligation when replacing with overseas like kind property. The tax does not go away unless the taxpayer dies and the beneficiaries receive a stepped up basis on the property. The beneficiaries receive the property at the market comparable value. Consequently, what the original taxpayer bought the property and the current value is not subject to taxes.
When selling real or personal property, consider the tax consequences of a 1031 exchange because once the transaction has closed, a 1031 exchange is too late, unless the transaction can be unwound. To learn “Ten Reasons Why a 1031 Exchange Makes Sense,” click on the button below for the free three page eGuide.