Investors who prefer to defer their payment of capital gains taxes when selling an investment property are sometimes interested in the details of executing a 1031 Exchange. A properly transacted 1031 can allow the taxpayer to sell an asset and reinvest the proceeds in other investment property while deferring the tax on any gains. This tool can contribute to leveraging success and is repeatable, compounding the value.
For example, suppose you buy a rental house for $200,000. Three years later, you want to buy an office park. You can sell the rental home for $300,000 but prefer not to pay the tax on the $100,000 gain you accrued in the rising market. If you complete the transaction using a 1031 exchange, you can defer the recognition of the gain and reinvest the entire proceeds. Further, you can continue this process with sequential exchanges. If you successfully maintain the deferral until your death, your heir will inherit the final properties with a stepped-up basis to their then-current value, effectively eliminating the tax.
What about State Capital Gains Taxes?
Most states impose a capital gains tax on top of the federal levy. The rates vary from a high mark of 13.3 percent in California to 2.9 percent in North Dakota (and zero in eight states). States that do not have a capital gains tax include Florida and Texas, which have no state income tax on ordinary or capital income. Again, the amounts and procedures vary. You can also defer these state capital gains taxes using the 1031 process. Some of these states have clawback provisions so that if the investor sells the replacement property later, the state retrieves the gain they would have taxed the investor on at that time.
One state that does not allow deferral of state capital gains taxes is Pennsylvania. Residents of the commonwealth must pay the tax on the gain, even if they have deferred at the federal level.
What Is the Advantage of Completing a 1031 Exchange?
Investors have varied reasons for wanting to replace one property in their portfolio with another. Most real estate assets are eligible for exchange using the tool, so investors that want to move from one geographic area to another (or spread out their holdings) can do so. Investors can also change sectors, perhaps switching from rental housing to hospitality or self-storage. Finally, a 1031 exchange is a feasible means of moving from direct ownership to fractional ownership, such as with a REIT. For investors seeking less active involvement, that may be a motivation.
Keep in mind that the process is complex and requires careful adherence to the rules. Investors must employ a Qualified Intermediary to complete the exchange, or the transaction will fail, and the taxes will be due.