Sellers of highly appreciated Real Estate find themselves facing very large capital gains taxes or considering the use of a qualified IRC Section 1031 tax deferred exchange. Consider the following:
- Pay the capital gains tax:
The current long term capital gain rate is 15% and can be as high as 20% for high income earners plus the lingering 3.8% Obama Care tax. What’s more, Uncle Sam will “recapture” all accumulated depreciation taken on the asset at a rate of 25%. By the way: depreciation recapture is always taxed first. Finally, state capital gains tax will be assessed at a rate of 3% in Idaho & a crushing 12.4% if your property is located in the Golden State of California.
- Use IRC Section 1031:
a) All of the above taxes are deferred & the tax basis from the relinquished property is carried forward into the replacement property. As a practical matter, the capital gains tax that would otherwise be paid is reinvested into the replacement property thereby allowing more leverage and growth potential. One could think of this technique as an interest free loan from the Federal Government for which no interest is charged and may never have to be repaid. (A full stepped up basis upon death of a spouse).
b) One of the “Safe Harbor” regulations dictates that replacement property (s) must be identified within 45 days of, and close escrow within 180 days of, close of escrow on the relinquished property.
The Practical Problem Today: NO INVENTORY TO EXCHANGE INTO!!
In markets where one desires to execute an IRC 1031 tax deferred exchange but replacement property choices may be limited, sellers can, and do, experience serious angst about the probability of locating & identifying a suitable replacement property(s) within the 45 day Safe Harbor.
Enter the IRC 1031 reverse exchange! This technique provides the same “Safe Harbor” rules as noted above, but in reverse. That is: One can purchase the replacement property first and then identify which relinquished property one will sell. The 45/180 day time lines still apply, but in reverse.
The reverse exchange technique is one that can take considerable anxiety off the table for a seller/exchanger who is confident that his relinquished property will indeed sell and close within the 180 day timeline allowed.
If you have general exchange questions or ideas, feel free to call or e – mail. I’d be happy to help you think them through.
Specific tax or legal questions related to the above should be directed to your tax/legal advisors.
Until next time,
Glenn
