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- Investment Property and 1031 Exchanges
Investment Property and IRC 1031 (Internal Revenue Code 1031)
Through leverage and financing, many Americans have enjoyed the benefits of home ownership. The concept of leverage allows an individual or entity to control an asset without having to tie up large amounts of cash. The investor realizes the gains on the total value of the underlying asset and also enjoys certain tax benefits. More and more Americans, disappointed with the returns from stocks and bonds, are looking to the real estate market as a way to diversify their portfolios.
The tool that offers the most benefit to owners of investment property is IRC (Internal Revenue Code) 1031 or more commonly referred to as a 1031 Exchange. The 1031 Exchange, when properly executed, allows the property owner to defer capital gains taxes. By deferring the capital gains, the property owner can increase his or her purchasing power provided by the tax deferral. The example below demonstrates this concept. The comparison assumes an investor makes a 25% percent down payment and finances 75% of the property (75% loan to value ratio) As this comparison illustrates, the investor who performs the 1031 exchange acquires $$1,011,200 more real estate than the investor who sold and paid taxes.
Example: Assume an investment property owner sells a rental property for $1,000,000. The owner originally purchased the property for $400,000. There is debt of $100,000 and property has been fully depreciated (assuming 80% of the property is depreciable). The investor has $600,000 of capital gain plus depreciation recapture of $320,000. They are in the top federal bracket and their state tax rate is 9%.
Depreciation Recapture:
$320,000 (depreciation recapture) x 25% = $80,000
Plus: Federal Capital Gain Tax:
$600,000 (capital gain) x 15% = $90,000
Plus: State Taxes
$920,000 x 9% = $82,800
Total Taxes Due on Sale $252,800
The following will demonstrate how the 1031 will allow the investor to acquire more property than if the investor sold the property
Sale:
Equity: $900,000
(Taxes Owed) $252,800
After Tax Equity $647,200
x4
New Property $2,588,800
Exchange:
Equity: $900,000
(Taxes Owed) $ 0
After Tax Equity $900,000
x4
New Property $3,600,000
Not only does the investor who performed the exchange acquire more property, he or she can preserve equity, increase cash flow from larger properties and maximize return on investment.
In order to take advantage of a 1031 exchange, the investor must follow two basic rules to completely defer the taxes on the gain realized from the sale of relinquished property.
1. The purchase price of the replacement property must be equal to or greater than the net sales price of the relinquished property; and
2. All cash received from the sale of the relinquished property must be used to acquire the replacement property
Property that qualifies for deferred gain treatment under Section 1031 must be “Like Kind” defined under the Code as follows:
1. Property held for productive use in a trade or business; or
2. Property held for investment.
The property can be: Vacant Land, Commercial Property, Apartment Buildings, Rental Homes. Said property cannot be: the investor’s personal residence and not property held for resale.
The preceding was intended to demonstrate the benefits an investor can enjoy under the IRC 1031. It was not intended to replace qualified legal or tax advice. Every investor should review their specific transaction with their own legal and tax counsel. Complete details regarding IRC 1031 are available at www.irs.gov.
About the author…Marla Trussell, MBA is a Howell Township resident and Realtor® with Coldwell Banker in Spring Lake. If you are interested in acquiring investment property or would like to exchange your investment property, please contact Marla at (732) 600-8743 or at www.marlatrussell.com.
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Capital Gains on the Sale of a Personal Residence
Some of you may be considering selling and moving to lower cost regions of the country; while others are using the equity to trade up to larger homes. Whatever the reason for selling your home, you should be aware of the tax implications and how to avoid hefty capital gains taxes in these times of great home appreciation.
Currently section 121 of the Internal Revenue Code allows an exclusion of up $250,000 of the capital gain on a principal residence for single taxpayers and up to $500,000 for a married couple filing jointly. To qualify, the taxpayer must own and use the home as a principal residence for at least two of the past five years prior to the sale. The ownership and use periods do not need to be concurrent. The two years must consist of 24 full months or 730 days.
What happens if you have lived in your primary residence for less than two years and need to sell your home? The IRS has allowed certain exceptions to the two year rule.
Job Relocation: Job relocation is defined by IRC 121 simply as “a change in the place of employment” for the purposes of a partial exclusion of gain from the sale of the home. An exception is permitted if the new job site is located at least 50 miles farther from the old home than old the workplace was from that home.
Health: An exception is permitted if the primary reason for the move is related to disease, illness, injury or if a physician recommends a change in residence for health reasons. In addition, a qualified person for health reasons includes close relatives, so that sales related to the caring of sick family members may qualify.
Other Unforeseen Circumstances: In addition to job relocation and illness, unforeseen circumstances may include the following:
§ Death,
§ Divorce or legal separation,
§ Unemployment, change in employment that leaves the taxpayer unable to pay the mortgage or reasonable living expenses,
§ Multiple births from the same pregnancy,
§ Damage resulting from natural disaster or man-made disaster, or war or acts of terrorism,
§ Condemnation or seizure or other involuntary conversion.
Reduced Exclusion Calculation: Prorated exclusion of gain is based on the number of days the homeowner meets the ownership and use of requirements, and the number of days between the most recent sale of a home using the Section 121 exclusion and the current sale.
Example: Bill and Sue purchased their new home in San Diego on October 1, 2002. Because of job relocation to Dallas, they sell their home on December 31, 2003. Under section 121, they qualify for a pro-rata exclusion calculated as follows:
Number of days owned and used as main home 456 456
Divide by 730 (days in a two-year period) .62
Times $500,000 maximum exclusion $310,000
Bill and Sue can exclude up to $310,000 of gain on a house they owned for 15 months.
The foregoing was not intended to replace qualified legal or tax advice. Every homeowner should review their case with their own legal and tax counsel. Complete details regarding IRC 121 are available at www.irs.gov.
Source: IRS Publication 523
About the author…Marla Trussell, MBA is a Howell resident and Realtor® with Coldwell Banker in Spring Lake in Olivenhain. If you are interested in selling your home, please contact Marla at (732) 600-8743 or at www.marlatrussell.com.
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