If you have a highly appreciated property for sale and you plan to sell it, then the IRC Section 1031 Exchange is the perfect for you. This strong powerful tool helps to increase wealth and saves you from paying heavy taxes. The IRC Section 1031 Exchange enables a family to avoid capital gains tax and to reinvest the profits in other properties.
According to the tax code, part A of the IRC Section 1031 Exchange 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."
The increase in capital gains tax rates w.e.f January 1, 2013 have made the IRC Section 1031 Exchange and CRT further more beneficial. Along with the increase in the rates of capital gains tax, a new healthcare tax on investment income has also been introduced that is 3.8%. This tax also includes the income received from the sale of property.
Successful execution of the IRC Section 1031 Exchange makes the tax payer eligible for many possible benefits. Following are some of them:
1. Tax Deferral (Immediate & Indefinite)
Using a 1031 exchange tool, a tax payer can easily defer capital gains tax. The deferred tax amount is reassigned to a substitute property. The tax payer can avoid paying this tax as long as he doesn't sell his or her replacement property without using a 1031 exchange. Since you can use the 1031 exchange for unlimited times, you can defer the tax for an unknown period.
This tool is also known as a tax deferred exchange which indicates that you can avoid taxes till a later date or until you sell your substitute property without the use of this tool. The subsititute property is sold accommodating the necessary taxes. However, it is possible to defer the tax if you plan to hold the replacement property until demise.
The current tax law allows the heirs of the descendant's property to get a step-up in the property's tax basis according to the fair market value in case of death. This credibly allows the heirs to pay minimal or no tax at all. Therefore, you can practically eliminate tax payments using a IRC Section 1031 Exchange if you hold the property until death.
2. Enhancement in Return on Investment (ROI)
A family can significantly increase their cash flow rate of return by using a 1031 exchange as compared to being without it. The usual cash flow rate of return for a farm or ranch is very low, so by employing IRC Section 1031 Exchange in the sale of a property, it can increase its wealth.
3. Consolidation or Diversification
Real estate investors who have accumulated multiple properties may eventually decide to combine their properties into one or a small number of larger assets. On the other hand, as is the case with most farm and ranch families, one big estate property can be used to get many different properties. Having different small properties at numerous locations spread out geographically can significantly cut down the amount of risk.
4. Elimination of Active Management of the Investment
It requires a lot of effort to run a farm or ranch. Buying real estate by selling a farm or ranch can allow a family to free themselves from daily maintenance activities. This can be done if the family exchanges its ranch or farm for real estate and other investments. However, on the other hand it is also possible for a family to earn by putting the property on rent and earn through it.
5. Wealth Building
Using a 1031 exchange allows an individual to preserve all of the net worth from the property that is practically not used. The seller can reinvest all the profits from sale of the property fully that doesn't include tax payments. The deferred tax amount allows families to reinvest that amount into other places hence increasing their family wealth and eventually generate large income for retirement years.
Example:
A Montana couple sells land for $5 million with a cost basis of $1 million. Assuming 2013 tax rates (23.9% combined federal and state capital gains tax and 3.8% Medicare Surtax), they will pay about $1,246,000 in taxes.
If this same couple would choose a 1031 exchange instead on the full $5 million sale, this $1,246,000 tax cost could be invested in further property. 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 more or less $4.8 million.
Not only would this duo 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!
The couple could benefit from this in the long run as well if they hold on to the property until death. If the real estate value climbs up, the heirs of the couple could get as much as nearly $500,000 added income from real estate.
There are complex rules and strict time parameters for completing a successful 1031 exchange.