In the time period leading up to the sale of a property, a seller often considers the capital gains tax that will need to be paid after the sale. For example, let’s consider an owner who originally paid $500,000 for an apartment property approximately 20 years ago. It is now under agreement to be sold for $1,000,000. The owner has claimed approximately $300,000 in depreciation in the past, thereby reducing the property’s basis to $200,000 – resulting in a taxable gain of approximately $800,000. With a total tax rate as high as approximately 40%, taxes of $320,000 would leave this owner with $680,000 on the sale of his $1,000,000 property – minus any outstanding financing. As this type of scenario is unacceptable to many sellers, they are often highly motivated to defer capital gains taxes.
In order to defer capital gains taxes, many sellers utilize a 1031 tax deferred exchange. If undertaken in strict accordance with IRS regulations, persons are allowed to defer taxes on the Capital Gain and depreciation recapture associated with a sale. In a 1031 tax deferred exchange, the seller is able to defer capital gains tax on his sale by acquiring another property, which (the replacement property) may have more desirable income and management characteristics than the property that was sold. In this way, the seller may be able to unlock the equity in his sold property in order to acquire a consistent source of income from a property of higher quality, with limited, or no, management responsibilities. In addition, the seller may increase his tax basis, which could have the result of sheltering much, if not all, of the income derived from the replacement property.
This deferral of capital gains tax may allow the exchanger to grow his net worth at a faster rate than if he had paid the capital gains tax and then invested the greatly reduced net proceeds in an alternative investment.The deferral of capital gains on the sale of real estate is considered by many real estate professionals to be one of the foremost wealth building tools in the real estate investor’s toolbox.
FAI Exchange and Sourcenet Investment Services, LLC, can help you through the process of a 1031 Tax-Deferred Exchange. To ensure effective execution, we will help in the preparation of exchange documents, preparation of the sales contract, as well as a review of the overall transaction.
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