In a tax-deferred exchange, the deferred gain is the amount of gain that escapes current taxation and is deferred until a later date.
For example, if an investor bought a property for $1,000,000 and claimed $100,000 in depreciation during ownership, the investor would have an adjusted basis of $900,000 ($1,000,000 purchase price less $100,000 depreciation).
Assuming the investor later sold the property for $1,200,000, the investment would be subject to capital gains tax on the $300,000 gain ($1,200,000 sales price less $900,000 adjusted basis). However, the resulting capital gains taxes may be deferred by completing a 1031 exchange.
To take advantage of a 1031 exchange, an investor must exchange into a “like-kind” property. Basically, it is a property of the same or higher value as the property being sold. The investor relinquishes one property and exchanges into a replacement property. This exchange allows the investor to defer capital gains on their investment property. The investor can continue doing 1031s, which will continue deferring gains. Assuming each property appreciates, the investor will have to find higher valued properties with each 1031 exchange.
A 1031 exchange has strict deadlines that must be adhered to. Otherwise, the investor will generate a taxable event. At some point, the investor may decide not to purchase another property. Because the investor is basically cashing out, the sale of this property will generate a taxable event.
A 1031 exchange applies to investment properties. Section 121 applies to a primary residence. When the primary residence is sold, section 121 allows excluding gains up to $250,000 for single filers and $500,000 for married filers. You must have lived in the home for two of the last five years to use this exclusion. This is also referred to as the “principal residence exclusion.”
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