Category: Personal Finance
Anytime you sell an appreciated asset, you owe capital gain tax. You can postpone payment of the tax by swapping or exchanging the property for another property. The rules for this type of a transaction are outlined in Section 1031 of the Internal Revenue Code.
For example, if you sell an office building that has appreciated in value, you will owe capital gain tax unless you swap the building for like-kind property. Before you initiate this transaction, be sure you understand the process and the timing issues.
Section 1031 Exchange
Section 1031 of the Internal Revenue Code allows the owner of real property held for investment, or personal property used in business, to swap or exchange this property for like-kind property. In so doing, the owner can postpone the recognition of the capital gain. As long as the owner continues to exchange existing property for another of equal or greater value, the capital gain continues to be postponed until a property is sold.
Real property held for investment, such as rental houses, office buildings, farmland, and commercial real estate, is eligible for a Section 1031 exchange. In addition, any personal property used in a business, such as corporate vehicles, computers, and office furniture can also be exchanged to avoid recognition of the capital gain or loss.
You can only swap "like-kind" property. Therefore, you can not exchange eligible real property for business personal property and vice versa. Likewise, any property, real or personal, held outside of the United States can not be exchanged for property that you own inside the United States.
You can not use a Section 1031 exchange for your personal residence or vacation home. Likewise, investment property does not include stocks, bonds, notes receivable, or partnership interests.
How Does it Work?
Let's use the office building as an example. Assume that you own an office building that was acquired ten years ago for $150,000. Today you have a purchase offer for $400,000. If you assume selling costs of $20,000 and a capital gain rate of 15%, selling the property for $400,000 will create a tax liability of $34,500. (This is calculated as: $400,000 - $20,000 = $380,000 - $150,000 = $230,000 X .15 = $34,500.)
To postpone the payment of the capital gain tax, you can find another office building of equal or greater value and trade with the owner for that property. Or, you can trade your building for vacant land, an apartment building, or any other "like-kind" real property that you would hold for business or investment purposes.
If you trade your $400,000 building for another property of lesser value, you will be required to pay a portion of the capital gain tax. Trading for a property of equal or greater value postpones all the tax until the acquired property is sold.
Using a Third Party
Because it is highly unlikely that the buyer of your building will have a property that you are interested in owning, it is often necessary to include a third party. You sell your property to your buyer and then you purchase the exchange property from another seller. To do this, you use an intermediary to temporarily hold the proceeds from the sale of your property, e.g. $380,000 from the building sale example, while you search for a property that you want to purchase.
However, time becomes an issue. You have 45 days from the sale of your office building to find a property to purchase. Within this time period, you need to have a written agreement to purchase a like-kind property. You have an additional 135 days to close the deal using the proceeds held by the intermediary. If you are not able to complete the purchase within this 180-day time frame, the Section 1031 exchange can not be accomplished and you will owe the capital gain tax.
Factors to Consider
1. Don't overpay for a property. The appeal of postponing capital gain tax may cause buyers to purchase property at higher than market value to meet the 45 day time period. Obviously, paying more for the property reduces the value of the tax deferral.
2. If you believe Congress will increase the capital gain tax rate of 15% in the future, you may be better off to pay the tax today instead of postponing it via a swap.
Get Competent Advice
Because of the decisions regarding suitable "like-kind" property and the required timing to do this type of a transaction, you should seek the advice of someone who is knowledgeable in this area, such as a tax accountant or real estate attorney. If you create a swap transaction that is later reversed by the Internal Revenue Service, you may be liable for not only taxes, but also penalties and interest.
Elaine E. Bedel, CFP®, is president of Bedel Financial Consulting, Inc., a fee-only wealth management firm providing financial planning and investment management services. For more information, visit their website at www.BedelFinancial.com or email to firstname.lastname@example.org.
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