First, it is not only the capital gains tax that the taxpayer will be deferring payment on, when transacting a Section 1031 exchange, it’s also the additional depreciation recapture tax on the relinquished property, as well as any State income taxes if any.
The rules are very complex for figuring out the recognized gain but are delineated by three rules when doing a Section 1031 exchange. Let me try to simplify these rules:
Rule # 1 – in order to totally defer payment of any tax due, the taxpayer needs to purchase replacement property (or properties) of equal value or more of the sales price of the relinquished property.
Rule # 2 – If the taxpayer purchased replacement property of lesser value than the sales price of the relinquished property, the taxpayer will be taxed on that difference. If the taxpayer does not use all of the proceeds from the sale of the relinquished property towards the purchase of the replacement property, the taxpayer could be taxed on the amount of the proceeds not used.
Rule # 3 – The taxpayer’s basis in the replacement property equals the fair market value of the replacement property less the amount of gain deferred by the taxpayer from the exchange.
EXAMPLE # 1: Taxpayer originally purchased an investment rental unit for $300,000.00 about 10 years ago. He has signed a contract to sell the apartment building for $500,000. There are no debts on the property. If this were a simple sale, the Taxpayer would have a paper profit of $200,000 and would have to pay capital gains tax on the $200,000 plus a recapture tax on the depreciation he took on the property over the 10 years he owned the property and any state income taxes, if any. But in this case, he is transacting a Section 1031 tax-deferred exchange and is purchasing a more expensive replacement property ($600,000). The taxpayer will be using all of the proceeds from the sale of the relinquished property, in order to purchase the replacement property. That results in a complete 1031 tax-deferred exchange and no tax would be due at this time.
EXAMPLE #2: Same example as above, but in this case, the taxpayer decides to obtain a mortgage in the amount of $250,000, as he needs some additional funds in order to close. He received $500,000 from the sale of the relinquished property, but still needs another $100,000 to close on the replacement property ($600,000). He borrows $250,000 at the time of closing on the replacement property. Leaving him with an extra $150,000 in his pocket ($500,000 (sales proceeds) + $250,000 (new loan), less the $600,000 (replacement property) = extra $ 150,000). He will be taxed on the $150,000, with the remaining sums of money qualifying for a Section 1031 exchange.
As you can see from the two examples, there can be different results depending upon the specific factual patterns.
One final comment, certain expenses are allowed to be deducted from the sales proceeds (customary costs of closing such as exchanger’s attorney’s fees, transfer fees on the deed, real estate commissions and title search fees, etc.). These extra deductions will allow the taxpayer to purchase a replacement property of lesser value as a result of these deductions. It is always recommended that the taxpayer discuss their factual pattern with their tax advisor and Qualified Intermediary prior to the signing of contracts to sell and/or purchase.
Liberty 1031 always recommends that the taxpayer consult with their tax and/or legal counsel on all matters dealing with the Internal Revenue Service.
Stephen Wayner is an attorney, Certified Exchange Specialist (CES), and Managing Director of Liberty 1031. Mr. Wayner is recognized as a leading authority on the subject of 1031 exchange transactions. He is a current board member of the Federation of Exchange Accommodators (FEA) and is the author of numerous books and articles on 1031 Exchanges and real estate investing.
Mr. Wayner has been cited as an expert on 1031 Exchanges in publications including USA Today, NewYork Times, Business Week, and The Wall Street Journal among many others.