Investors often aim to use a 1031 exchange as a strategy to postpone the payment of capital gains taxes when selling property. This approach can potentially boost the funds available for reinvestment, thereby enhancing the investor's ability to leverage their investment power. By engaging in sequential exchanges, this effect can be compounded, enabling the potential for portfolio growth. Many investors find this to be a logical approach.
This rationale has led some taxpayers in the past to push the boundaries of what types of property they could exchange, including collectibles, intellectual property, and precious metals. While gains from the sale of stocks and securities have never qualified for such exchanges, there have been cases where other types of property were eligible. Prior to the passage and implementation of the Tax Cuts and Jobs Act (TCJA), coins, artwork, and even antiques were sometimes approved for exchanges.
Nevertheless, even before the IRS tightened its criteria, certain restrictions were already in place. For instance, previous rulings by the IRS rejected attempts to exchange gold for silver, deeming them as not meeting the requirement of being "like-kind." Additionally, the exchange of gold coins for gold bullion was also disallowed.
Following the enactment of the Tax Cuts and Jobs Act (TCJA), there were significant changes to the eligibility of assets for like-kind exchanges. Under the TCJA, the scope of like-kind exchanges was narrowed down to only include real estate. This exclusion meant that assets other than real estate, such as collectibles, intellectual property, and valuable metals, were no longer eligible for tax-deferred exchanges.
In response to the TCJA, the Internal Revenue Service (IRS) took steps to provide further clarification on the statutory limitations and parameters of like-kind exchanges. One such clarification came in the form of Regulation REG-117589-18, issued by the IRS. This regulation aimed to define and specify the types of properties that qualified as real property for the purpose of like-kind exchanges.
According to REG-117589-18, real property, for the purposes of a like-kind exchange, is defined as encompassing various elements. These elements include land, improvements made to land, unsevered crops, natural products of the land, and even the water and air space that are directly adjacent to the land. It is important to note that this definition extends to include permanent structures such as roads and bridges, which are considered integral components of the real property.
By providing this detailed definition of real property, the IRS aimed to establish clear guidelines for taxpayers and investors engaging in like-kind exchanges. These guidelines outlined the specific types of assets that would still qualify for tax-deferred treatment under the revised rules set forth by the TCJA.
How do 1031’s work?
A 1031 exchange is a valuable tool for taxpayers who own real estate and wish to optimize their investment strategy. Let's delve into how it works. Imagine you are a real estate owner with an apartment building located in one state. However, you have a desire to shift your focus to another geographical area or change the composition of your portfolio by eliminating residential assets and acquiring industrial properties instead.
In this scenario, if you decide to sell the apartment building, you will be subject to capital gains taxes. The capital gains tax is calculated based on the difference between your initial purchase price (referred to as the basis) and the current market value at which you can sell the property.
To illustrate, let's assume you purchased the apartment building for $500,000, and its current value is estimated at $1,000,000. This signifies an increase of $500,000 in value (while considering any adjustments to the basis). Depending on your income level, you could potentially face a tax bill of up to $100,000 (assuming you have owned the property for more than a year and qualify for long-term capital gains tax rates).
Now, here's where the 1031 exchange comes into play. By executing a 1031 exchange, you have the opportunity to defer the payment of capital gains taxes and reinvest the entire $500,000 profit into a new property. Instead of paying the taxes immediately, you can utilize the funds to acquire a replacement property that aligns with your investment goals. This deferral allows you to leverage the full amount of your profit for reinvestment, thereby enhancing your investment power and potential returns.
By taking advantage of a 1031 exchange, you can defer the tax liability and maintain a larger pool of funds to invest in new properties. This strategy enables you to strategically reposition your real estate portfolio and pursue investment opportunities that align with your long-term objectives.
Repeating the Exchange Transaction
Engaging in a 1031 exchange does not completely eliminate the obligation to pay capital gains tax. While the exchange allows you to defer the tax payment by reinvesting the proceeds into a replacement property, if you eventually sell that replacement property, the capital gains tax will come into play. At this point, you will not only owe tax on the gain from the sale of the replacement property but also the deferred tax from the original asset.
However, there is an intriguing aspect to consider: the potential for successive exchanges and the opportunity to continuously defer the tax liability. By repeating the 1031 exchange process with subsequent property sales, you can continually defer the capital gains tax and reinvest the funds into new replacement properties. This strategy can potentially enhance your investment power and facilitate portfolio growth over time.
Another noteworthy aspect to explore is the possibility of completely avoiding capital gains tax by holding onto the investment until you pass away and bequeathing it to your heir(s). In this scenario, when the property is inherited, the heir(s) will receive it at a stepped-up value, which is determined by its fair market value at the time of your death. Consequently, the heir(s) will not be liable for any tax on the gains that accrued prior to your passing.
This stepped-up basis allows for a reset in the tax calculation, erasing the previously deferred gains. As a result, your heir(s) can potentially inherit the property without incurring any tax liability on the accumulated gains up to that point. This can be a substantial benefit for striving to preserve wealth and passing it on to the next generation.
By leveraging the strategy of successive 1031 exchanges and potentially utilizing the stepped-up basis upon inheritance, taxpayers can effectively manage their tax obligations and attempt to maximize the benefits of deferring capital gains tax. It is essential to consult with tax professionals and estate planning experts to ensure proper execution and compliance with applicable tax laws and regulations.
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
Securities offered through Emerson Equity LLC, member FINRA / SIPC. This is not an offer to buy or sell securities. Securities investing carries an inherent risk of loss of some or all of the principal invested. We are not tax professionals. You should always discuss your investments with a tax professional prior to investing. Securities are sold only in those states where Emerson Equity LLC is registered. Perch Wealth LLC and Emerson Equity LLC are not affiliated. COMPANY and Emerson Equity LLC do not provide legal or tax advice. Securities offered through Emerson Equity LLC Member FINRA / SIPC and MSRB registered. Emerson Equity LLC is unaffiliated with any entity herein.
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Perch Financial LLC and Emerson Equity LLC do not provide legal or tax advice. Securities offered through Emerson Equity LLC Member FINRA/SIPC and MSRB registered. Emerson Equity LLC is unaffiliated with any entity herein. 1031 Risk Disclosure:
There is no guarantee that any strategy will be successful or achieve investment objectives;
Potential for property value loss – All real estate investments have the potential to lose value during the life of the investments;
Change of tax status – 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;
Potential for foreclosure – All financed real estate investments have potential for foreclosure; ·Illiquidity – Because 1031 exchanges are commonly offered through private placement offerings and are illiquid securities. There is no secondary market for these investments;
Reduction or Elimination of Monthly Cash Flow Distributions – Like any investment in real estate, if a property unexpectedly loses tenants or sustains substantial damage, there is potential for suspension of cash flow distributions;
Impact of fees/expenses – Costs associated with the transaction may impact investors’ returns and may outweigh the tax benefits
No offer to buy or sell securities is being made. Such offers may only be made to qualified accredited investors via private placement memorandum. Risks detailed in a private placement memorandum should be carefully reviewed, understood, and considered before making such an investment. Prospective strategies and products used in any tax advantaged investment planning should be reviewed independently with your tax and legal advisors. Changes to the tax code and other regulatory revisions could have a negative impact upon strategies developed and recommendations made. Past performance and/or forward-looking statements are never an assurance of future results.
Many of the investments offered will be only available to those investors meeting the definition of an Accredited Investor under SEC Rule 501(A) and offered as Regulation D private placement securities via a Private Placement Memorandum (“PPM”). Prospective investors must receive, read, and understand all the risks associated with buying private placement securities. Investments are not guaranteed or FDIC insured and risks may include but are not limited to illiquidity, no guarantee of income or guarantee that all tax advantages or objectives will be met and complete loss of principal investment could occur.
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