When an investor earns a profit through selling an asset, the IRS taxes the income as a capital gain. If the owner held the investment for less than a year before selling, the growth is classified as short-term, and the tax rate is the same as that taxpayer’s ordinary income. Depending on the individual’s income level, that tax rate may be as high as 37 percent.
On the other hand, if the taxpayer owned the asset for more than a year and then sold it, they would owe taxes at the long-term capital gains rate, which tops out at 20 percent. In either case, the amount subject to tax is determined by calculating the difference between the adjusted basis (the original purchase price plus any out-of-pocket expenses and improvements) and the sales price.
Deferring taxes with a 1031 exchange.
If the investor is reinvesting the proceeds and prefers to defer paying the capital gains taxes, they can execute the transactions using a 1031 exchange. The 1031 exchange is a process documented in IRC section 1031 regarding "like-kind exchanges." Since the IRS allows taxpayers to defer payment of capital gains using this method, the process is governed by rules and tight timelines. Among the critical provisions are these requirements:
- The investor must identify potential replacement properties within 45 days of the initial sale and complete the transaction within 180 days.
- The investor must reinvest the entire proceeds by buying new properties with the same or higher value than the relinquished asset and with equivalent or greater debt.
- A Qualified Intermediary must hold the proceeds, formalize the identification of replacement assets, and maintain all relevant documentation for the transaction. In addition, the investor mustn't have access to the proceeds during the exchange period.
What is boot in a 1031 exchange?
The boot is any amount of value that is not replaced by the acquisition of equivalent properties. For example, suppose that you want to divest a residential rental valued at $400,000, on which you have made a profit of $50,000. If you want to defer the payment of capital gains taxes on the appreciation, you must reinvest not just what you gained by holding the property but the entire proceeds of the sale.
If you sell the investment property for $400,000, you need to buy a new property or properties for at least $400,000. If you reinvest a smaller amount, the remainder is considered boot and is taxable. If the sale takes place less than a year after your initial property purchase, you will pay taxes on the boot at your ordinary income rate. The boot is taxed at the lower capital gains rate if you sell the property more than a year after buying it. Still, the goal for an investor using a 1031 exchange for the transaction is most likely to defer paying taxes on the entire amount. To do that, they must buy property equal to or greater than the disposition proceeds.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.
Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.
Costs associated with a 1031 transaction may impact investor's returns and may outweigh the tax benefits. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities.
