Is a 1031 Exchange Right for You?
A 1031 exchange, on the surface, is a simple yet powerful technique that helps real estate investors. It lets investors essentially "trade" properties while postponing taxes on any potential gains. The rules are complicated, and there have been some recent changes to the rules that all investors should be aware of.
The Tax Cuts and Jobs Act continues to allow investment property owners to defer the potential tax liability using Section 1031 tax-deferred exchanges, which have been in the tax code since 1921. No new restrictions on 1031 exchanges of real property were made in the tax law. However, the tax law repeals 1031 exchanges for all other types of property that are not real property. What does this mean?
This means that 1031 exchanges of personal property, collectibles, aircraft, franchise rights, rental cars, trucks, heavy equipment and machinery will no longer be permitted.
There were no changes made to the capital gains tax rates. An investment property owner selling an investment property can potentially owe up to four different taxes:
- Depreciation recapture at a rate of 25 percent.
- Federal capital gains taxed at either 20 percent or 15 percent, depending on taxable income.
- 3.8 percent net investment income tax (NIIT) when applicable.
- The applicable state tax rate, which is as high as 13.3 percent in California.
Some investors and private equity firms won't have to reclassify carried interest compensation from the lower capital gains tax rate to the higher ordinary income tax rates. But to qualify for the lower capital gains tax rate on carried interest, investors will now have to hold these assets for three years instead of the former one-year holding period.
So, let's take a step back and see what Section 1031 states: "No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like-kind which is to be held either for productive use in a trade or business or for investment."
This is powerful protection: Tax-deferred exchanges allow investors to defer taxes, as well as facilitate significant portfolio growth and increased return on investment. To access the full potential of benefits, it's crucial to understand the exchange process and Section 1031 code.
For instance, what's the definition of like-kind property? Any property held for productive use of trade or business or for investment can be exchanged for any other property held in productive use in trade or business or for investment—these properties are like-kind to one another. The rules can be subtle and complicated, however, so you'll need to get expert advice—don't make assumptions. You should always review all aspects of specific facts and circumstances with your tax and legal advisors.