InSight

Tax Mitigation Playbook: What is a 1031?

Financial Planning Dentist

A 1031 exchange, also known as a like-kind exchange or tax-deferred exchange, is where real property that is “held for productive use in a trade or business or investment” is sold and the proceeds from the sale are reinvested into a like-kind property intended for business or investment use, allowing the taxpayer, or seller, to defer the capital gains tax and depreciation recapture on the transaction.

The property sold as part of a 1031 exchange is the Relinquished Property. The property purchased is the Replacement Property. The real property in a 1031 exchange must be like-kind; most real estate is like-kind to all other real estate. For example, an office building could be exchanged for a rental duplex, a retail shopping center could be exchanged for farmland, etc. 

During a 1031 exchange, neither the taxpayer nor an agent of the taxpayer can receive or control the funds from the sale of the property. If a taxpayer has direct or indirect access to the funds, a 1031 exchange is no longer valid. A qualified intermediary is used to hold the proceeds of the Relinquished Property sale until it is time to transfer those proceeds for the close of the Replacement property.

To be eligible for a 1031 exchange the person or entity must be a US taxpaying identity. This includes individuals, partnerships, S-corporations, C-corporations, LLCs, and trusts. However, it is a requirement that the same taxpayer sells the relinquished property and purchases the replacement property for a valid exchange. 

1031 exchanges were first authorized in 1921 because Congress saw the importance of people reinvesting in business assets and they wanted to encourage more of it. There have been changes and additions to the regulations that govern 1031 exchanges, and the most recent changes impacting real estate in a 1031 exchange were in 2001.

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We’re currently looking for major overhauls in taxation for corporations and people in the coming years. General civil unrest, combined with decades-long examples of corporations and individuals paying no and very little taxes, is causing a groundswell of discussion in Washington regarding changes to the IRS practices, the rules for carried interest, and the tax bracketing system. Couple this with a massive infrastructure bill on the heels of the Jobs and Tax Cuts Act and the U.S. is finally feeling the pressure to pay for the spending it has racked up since 2008.  The easiest way to pay for this 13-year long spending spree will be to turn to the corporations and people who have seen their fortunes impacted the most. The “tax the rich” cries are ringing out from both parties and a need to bring taxes up to resolve debt is becoming more and more immediate.  The first pitch in this game has come from the Biden administration. With several proposed changes affecting inherited wealth, treatment of capital gains, and raising the corporate tax rate back to the 2010’s range. There will be huge shifts for the wealthiest Americans, and even for those who will dip into that range for a year or two as they sell property, their businesses, and begin shifting assets to the next generation. Taking steps to defer your federal income bill is usually a good idea, especially if you expect to be in the same or lower tax bracket in future years. If that assumption pans out, making moves that lower your current-year income will, at a minimum, put off the tax day of reckoning and leave you with more cash until the bill comes due. If your tax rate turns out to be lower in future years, deferring income into those years will cause the deferred amount(s) to be taxed at lower rates. Great. This confluence of historically high pent-up capital gains and what might be a purge of those positions in 2021 to avoid the tax consequences in the years to come has made for a major (albeit temporary) shift in the tenured financial advice many are used to. Some elements will still support the goals and efforts of workers, but many will be turned on their ear and are downright bad advice given these proposed changes. Additional Resources for ‘Taxmageddon’ Tax Mitigation Playbook Download Opportunity ZoneOverview

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