The IRC Section 1031 Exchange is one of the most powerful tax saving and wealth building tools available for people selling highly appreciated real estate. A properly structured 1031 exchange allows a family selling a farm or ranch to sell land, to reinvest the proceeds in other “like-kind” real estate, and to defer capital gain taxes.
To quote the tax code, IRC Section 1031 (a)(1) 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.”
Effective January 1, 2013, capital gains tax rates have increased, making tax-saving strategies such as the 1031 Exchange and Charitable Remainder Trust even more advantageous. In addition to higher capital gain tax rates, there is a new 3.8% healthcare tax on investment income including income from the sale of real estate.
There are many potential benefits for a taxpayer who successfully executes a 1031 exchange. Some of these include:
1. Tax Deferral (Immediate & Indefinite)
In a properly executed 1031 exchange, capital gain taxes are deferred and transferred to replacement property. Tax is not due until the taxpayer sells the replacement property without utilizing a 1031 Exchange. Since there is no limit to the number of exchanges a taxpayer can complete, it is possible to defer the payment of tax indefinitely.
The 1031 exchange is commonly referred to as a tax “deferred” exchange, implying that taxes are not eliminated, only deferred until the replacement property is later sold in a taxable transaction. However, it is possible to potentially eliminate capital gain taxes altogether on the sale of property by exchanging into and holding property until death. Under current tax law, heirs of a descendant’s property receive a “step-up” in basis of the property’s tax basis to its fair market value upon death. This step-up in basis could conceivably enable the heirs to inherit property and then sell the property for fair market value soon after the decedent’s death and pay little or no tax. Thus, by employing the 1031 exchange until death, it may be possible to not only defer taxes on the sale of property, but permanently eliminate them. Some refer to this strategy as “swap until you drop”.
2. Improvement in Return on Investment (ROI)
A typical farm or ranch has a very low cash flow rate of return. By selling and exchanging land into other types of commercial real estate such as office buildings, a family may be able to increase their annual cash flow rate of return.
3. Consolidation or Diversification
Real estate investors who have accumulated multiple properties may eventually decide to consolidate their properties into one or a small number of larger assets. Conversely, as is the case with most farm and ranch families, one large real estate asset can be exchanged into multiple properties. Exchanging into different types of properties and in different geographic locations can be an effective risk reduction strategy.
4. Elimination of Active Management of the Investment
Operating a farm or ranch involves a lot of hard work. Exchanging farm and ranch land into other passive real estate investments or into properties that are professionally managed, may enable a family to free themselves of the day-to-day activities of running their farm or ranch. Ironically, an agricultural family can often sell their place and increase their income without having to work as hard for it.
5. Wealth Building
The greatest potential benefit from using a 1031 exchange may be the ability to preserve all of the equity in the relinquished property. Deferring taxes on a sale allows the seller to reinvest the full sales proceeds, undiluted by tax. The ability to invest the money that would have gone to taxes in additional real estate may enable a family to grow wealth and generate more income for retirement.
Consider the following example: A Montana couple sells land for $5 million with a cost basis of $1 million. Assuming 2016 tax rates (23.9% combined federal and state capital gains tax and 3.8% Medicare Surtax), they will pay approximately $1,246,000 in taxes.
If this same couple were to do a 1031 exchange on the full $5 million sale, this $1,246,000 tax cost could be invested in additional real estate. Assuming the real estate grew at an average annual compound rate of 7% (income plus appreciation), in 20 years this $1,246,000 would be worth approximately $4.8 million.
Not only would this couple benefit from the additional income the real estate would generate while they are alive, if they hold the property until they die and if real estate continues to receive a step up in basis upon death, they could potentially pass close to $5 million more to their heirs!