Written By: Justin Oh CPA
When you own an existing commercial real estate and you want to sell and find a more profitable property to purchase, you should consider if this sale and purchase is a 1031 exchange. The 1031 exchange has the advantage of deferring taxes on capital gains incurred at the time of sale and not having to pay it at the time of sale. The 1031 exchange requires an additional cost due to the intervention of an intermediary, which in most cases does not exceed $2,000. For example, if the long-term transfer tax is approximately 20% of the federal/state combined, and the transfer income is more than $10,000 (= $2000 / 20%), you will have to see if the 1031 exchange is an economically appropriate option for the individual (e.g. Mr. Kim).
Then, if Mr. Kim sold a rental building in California and earned a capital gain of $100,000, looking at how much tax he would have to pay in exchange for 1031, the federal government 15% (income from depreciation $25%) plus the California government tax rate can defer taxes of about $25,000 or more. Some will object and argue that 1031 The exchange only delays the tax and does not eliminate it. Eventually, the property must be sold, and taxes paid since you can’t take it to the grave. However, you must note that while you can’t take the property to the grave, personal taxes on capital gains can be buried with yourself when you die. In other words, in the case of inheriting the real estate purchased by the descendants or relatives at 1031, the market price at the time of death is handed over to the heir, so that the heir who sold it can avoid the full amount of capital gains tax.
In the case of Mr. Kim mentioned above, for example, a rental building that was purchased for $500,000 30 years ago was exchanged several times for a more expensive building without paying taxes in exchange for 1031, resulting in $3 million. At this time, for convenience, if you calculate capital gains without considering depreciation, you have to pay at least $500,000 in capital transfer tax with $2.5 million. However, instead of disposing of it, Kim handed it over to his child as an inheritance, and he disposed it immediately after the child inherited the property, saving 500,000 dollars in tax.
In this way, if the 1031 exchange is used well, it is not only the effect of deferring the tax, but it can be completely avoided. Therefore, it is believed that the hassle of the exchange should not cause the trouble of avoiding it.
However, if the cumulative passive deficit carried over in the past exceeds the capital gains, or if you can get exemption from capital gains of up to $500,000 by changing it into your own residence, selling it is more economical than 1031 exchange. We recommend that you do this in consultation with an expert.
In order to extend the transfer tax through 1031 exchange, the amount generated during the sale was tied up using an escrow company, and even if another real estate was purchased and exchanged with that amount, it was not recognized as a 1031 exchange. You need to be more careful about this. Therefore, to extend the transfer tax by exchanging 1031, you must use an intermediate company in charge of exchanging 1031 and keep the sales amount until you purchase the next sale.
