Utilizing 1031 Exchanges for Tax Deferral in Investment: Exploring Property Eligibility and Limitations
Investors often aim to defer capital gains taxes through 1031 exchanges, which boosts funds for reinvestment and enhances investment leverage. Sequential exchanges have the potential to compound these benefits, helping to facilitate the possibility of portfolio growth. Some taxpayers have attempted to expand the scope of eligible properties, including collectibles, intellectual property, and valuable metals.
While stocks and securities do not qualify, certain items like coins, artwork, and antiques were occasionally eligible before the Tax Cuts and Jobs Act (TCJA). Nonetheless, even with looser regulations, the IRS imposed restrictions, such as disallowing gold-for-silver exchanges and gold coin-for-bullion exchanges.
TCJA Exclusion and IRS Rulings on 1031 Exchanges
Following the enactment of the TCJA, the scope of 1031 exchanges was narrowed down to exclusively include real estate. The IRS provided further clarification through rulings such as REG-117589-18, which outlined the statutory limitations on like-kind exchanges. According to this regulation, real property encompasses land, land improvements, unsevered crops, natural products of the land, and adjacent water and air space. It also encompasses permanent structures like roads and bridges.
Understanding the Basics of a 1031 Exchange
A 1031 exchange is a valuable tool for real estate owners. It allows them to strategically shift their investments without incurring immediate capital gains taxes. Here's how it works:
- Scenario: Suppose you own an apartment building in one state but want to shift your focus to a different area or change your portfolio composition, such as moving from residential to industrial properties.
- Capital Gains Taxes: If you sell the apartment building, you would typically owe capital gains taxes on the profit, which is the difference between the purchase price (basis) and the selling price.
- Tax Liability Example: Let's say you bought the apartment building for $500,000, and it's now valued at $1,000,000. This represents a profit of $500,000 (after considering adjustments to the basis). Depending on your income and eligibility for long-term capital tax rates, your tax bill could be as high as $100,000.
- Deferring Taxes: By executing a 1031 exchange, you can defer the tax payment and reinvest the entire $500,000 profit into a new property.
In summary, a 1031 exchange allows you to defer capital gains taxes and reinvest the proceeds into another property, thereby seeking to maximize your investment potential.
Exploring Sequential 1031 Exchanges and Tax Deferral Strategies
While a 1031 exchange allows you to defer capital gains tax, it's important to note that the tax is not eliminated entirely. If you eventually sell the replacement property acquired through the exchange, you will owe capital gains tax on any profit from that sale. Additionally, you will also be liable for the deferred tax on the original asset.
However, there is a potential strategy to continue deferring the tax liability. By deferring the tax until the point of transferring the property to an heir through inheritance, it becomes possible to entirely avoid the capital gains tax. This is due to the concept of a stepped-up value for inherited assets.
When the property is inherited, the heir receives it at its stepped-up value, which is determined based on its worth at the time of the original owner's death. This stepped-up value becomes the new basis for the heir, and no tax is due for any gains that occurred prior to the inheritance.
By carefully planning and utilizing this strategy, investors can effectively defer their tax obligations through sequential 1031 exchanges and ultimately pass on the property to heirs, allowing them to enjoy the benefits of a stepped-up basis and avoiding capital gains tax on prior gains.
Not an offer to buy, nor a solicitation to sell securities. All investing involves risk of loss of some or all principal invested. Past performance is not indicative of future results. Speak to your finance and/or tax professional prior to investing. Any information provided is for informational purposes only.
Securities offered through Emerson Equity LLC Member: FINRA/SIPC. Only available in states where Emerson Equity LLC is registered. Emerson Equity LLC is not affiliated with any other entities identified in this communication.
1031 Risk Disclosure:
· There’s no guarantee any strategy will be successful or achieve investment objectives;
· All real estate investments have the potential to lose value during the life of the investments;
· The income stream and depreciation schedule for any investment property may affect the property owner’s income bracket and/or tax status. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities;
· All financed real estate investments have potential for foreclosure;
· These 1031 exchanges are offered through private placement offerings and are illiquid securities. There is no secondary market for these investments.
· If a property unexpectedly loses tenants or sustains substantial damage, there is potential for suspension of cash flow distributions;
· Costs associated with the transaction may impact investors’ returns and may outweigh the tax benefits