Internal Revenue Service Section 1031 exchange has garnered renewed interest from CPAs, tax attorneys and individual investors as a result of higher federal capital gain tax rates effective January 1, 2013. A 1031 exchange defers the federal and state capital gain and depreciation recapture taxes when selling real and personal of equal or greater value property productively used in a trade, business or investment and replaced with like kind property within 180 calendar days of the initial closing. Real property such as land, condominium, multi-unit apartment complexes, shopping malls can be exchanged for other real property while aircraft, equipment, livestock, vintage or collectible cars, artwork and precious metals must be exchanged for like-kind personal property.
Capital Gains Tax
Capital gain is the increase in value realized when the asset is sold. A capital loss is when the sales price is less than the purchase price. Short term capital gain is when the asset is sold within a year of the purchase while long term gain is property held for more than one year and a day. Short term capital gain is taxed as ordinary income and long term capital gain is taxed by the new rates placed into effect January 1, 2013. Ordinary income means the gain is added to the taxpayer’s current income, resulting in a higher tax than long term capital gain rates. A lower capital gains tax is meant to encourage investment. 2013 capital gain tax rate follows:
The long term capital gain rate use to be 15 percent, but now for the highest income earners the rate 23.8 percent. On collectibles, the long term capital gain rate is 28 percent.
Capital assets are the building blocks of capitalization rates, amortization, depreciation, capital gains and 1031 exchanges. A capital asset is any real, tangible and intangible personal property held as an investment or for use in business or trade. Excluded is inventory or property held primarily for personal use and consumption. Tangible capital assets provide an offset to income in the form of depreciation, given a useful life of one year or more, can wear out, decay or become obsolete due to natural causes. Examples of depreciable capital assets include self-storage facilities, apartments, commercial buildings, aircraft, office furniture, livestock, heavy and light industrial equipment and medical equipment. Intellectual property, patent rights, and trademarks are examples of intangible personal property.
Tangible capital assets are depreciated over their useful lives. Depreciation is the continuous and the immutable decline in the value of the capital asset. The decline can offset or lower net income. Land cannot be depreciated. If there is a structure or the land is improved, those capital improvements can be depreciated over time. Banquet room dividers in hotels have an established useful life. Aircraft and dairy and breeding cattle are depreciated on a 5-year schedules.
For tangible property, the capitalized cost (basis) is recovered over a standard life by annual deductions for depreciation. The tax depreciation system in the U.S. Is the Modified Accelerated Cost Recovery System (MACRS). When the capital asset is sold, the Internal Revenue Service imposes recaptured depreciation to tax the gain because a deduction from ordinary income over the useful life of the capital asset was received.
The federal and state capital gain and depreciation recapture can represent as much as 40 percent of the sales price. If the taxpayer’s intent is to replace the asset, then a 1031 exchange is a recognized strategy to defer the recognized gain or tax. The 1031 exchange is effectively an indefinite, interest free loan versus paying the tax and borrowing funds to acquire another asset. The higher capital gain rates have been attributed to an increase in the number of 1031 exchanges initiated. Given the appropriate fact pattern, a 1031 exchange makes sense.