YOU plan to sell an apartment building that you purchased 10 years ago at $300,000. It is now worth $800,000. You want to sell but are worried about potential taxes. And rightly so. Your tax preparer computes capital gains and gives you a combination of good and bad news. The good news: the capital gain tax rate has come down dramatically to an all-time low of 15 percent. The bad news: depreciation that has accumulated all these years has decreased your basis. The result is a big gain. And big tax. Should you sell? Your realtor mentioned an out: 1031 exchange. This would allow you to dispose of the property without paying taxes now. Too good to be true? Let’s explore reasons to exchange, or not to exchange.
Why you should use 1031 exchange:
1. Defer paying taxes. The prospect of paying taxes on built-in gain is never welcome. A potential combined tax rate of 40 – 50 percent is a potent reason to structure an exchange that can defer a substantial capital gains tax.
2. Upgrade size or quality of investment. A small, management intensive property with headaches galore can be exchanged for a large, less demanding apartment, shopping center, or commercial holding that can be managed professionally.
3. Change investment location. Take advantage of the exchange to relocate from, say, a neighborhood on the decline to a better location with tremendous growth potential.
4. Increase tax basis and depreciation write off. Utilize the exchange to acquire a property of greater value. And greater depreciation deduction.
5. Utilize an exchange to generate cash flow from a property held for investment (land without income) to a property with rental income (residential or commercial rental).
6. Break up a tenancy in common. You may want to go on your own by disposing of a property owned with others to a property that you own 100 percent.
7. Estate planning. Selling a highly appreciated property now will cause substantial income taxes. Exchange and leave it to your heirs who can then benefit from stepped up basis for property acquired from a decedent. We are talking substantial tax savings.
Why you should not use 1031 exchange:
1. You are merely postponing taxes, not actually saving income taxes.
2. The basis on the new property will be low. Depreciation will also be low.
3. It is too complicated to structure and implement.
4. You need tax advice but are not willing to pay for it.
5. You don’t have the patience to deal with intermediaries or wait months to consummate the deal.
6. You have a negative taxable income and can absorb the gain without paying too much taxes.
7. You need cash from sale. Cash received is boot and will be taxed.
8. You have expiring capital loss, net operating loss, and business credit carryforwards
9. Charitable contribution carry forwards will be expiring.
10. It’s difficult to find a good and reasonable replace property within 45 days and close within 180 days.
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Victor Santos Sy, CPA, MBA, provides professional services in accounting and tax controversy including IRS audit defense and offers in compromise. He also advises clients on choices of entity including corporations for small businesses and LLCs for rentals. Vic worked with SyCip, Gorres, Velayo (SGV – Andersen Consulting) and Ernst & Young before establishing Sy Accountancy Corporation at 704 Mira Monte Place, Pasadena, CA 91101. The firm celebrates its 35th anniversary this year. You may email tax questions to Vic at [email protected]. You are welcome to visit our website for more than 300 tax tips at www.victorsycpa.com.
