What Does “Indefinite” Tax Deferral Mean in a 1031 Exchange?
The primary benefit of conducting a 1031 exchange is that it allows for deferral of the capital gains tax that would otherwise be owed as a result of selling a “relinquished” property. This is commonly referred to as “indefinite” tax deferral. What does this mean, exactly? Find out from a 1031 exchange expert at 1031 National Services:
Understanding the Meaning of “Indefinite” Tax Deferral
Under Section 1031 of the Internal Revenue Code, a U.S. taxpayer who conducts an “exchange” of like-kind properties is eligible to defer any capital gains tax that would be triggered by the sale of relinquished property. This potential capital gains tax liability would be due to—and calculated based upon—the property’s appreciation in value. Generally speaking, upon the sale of appreciated real estate held for a year or longer, a taxpayer must pay capital gains tax determined by the difference between the sale price of the property and the taxpayer’s basis in the property (i.e., the purchase price).
Section 1031 allows taxpayers to defer this tax liability indefinitely.
Here’s how it works:
When a taxpayer conducts a 1031 exchange involving the sale of appreciated real estate, the taxpayer’s obligation to pay capital gains tax is deferred. The key question is: Deferred until when?
Technically, the taxpayer’s obligation to pay capital gains tax triggered by the sale of the relinquished property is deferred until the taxpayer sells the “replacement” property acquired through the exchange. However, if the taxpayer conducts another 1031 exchange in which the replacement property becomes the relinquished property, the taxpayer’s capital gains tax is deferred again. Section 1031 allows taxpayers to continue conducting 1031 exchanges indefinitely, meaning that their capital gains tax deferral on each exchange in the chain is also deferred indefinitely.
Over time, this can result in substantial tax savings.
It is also important to keep in mind that the obligation to pay capital gains tax is only triggered upon the sale of a replacement property, and only if the replacement property is not sold through another 1031 exchange. Thus, if a taxpayer never sells a replacement property, then the obligation to pay capital gains tax on the sale of the relinquished property never comes into play. By also deploying other estate planning and tax planning strategies, it will often be possible to avoid (or at least substantially mitigate) any tax liability without conducting a subsequent 1031 exchange.
When Can Tax Deferral Under Section 1031 End?
With this in mind, when can tax deferral under Section 1031 end? Generally speaking, the tax deferral achieved through a 1031 exchange ends when a taxpayer sells a replacement property outside of a 1031 exchange. At this time, the entire outstanding amount of capital gains tax becomes owed to the IRS. Importantly, once a taxpayer’s capital gains tax liability has been triggered, this generally cannot be undone. As a result, if the goal is to conduct a subsequent 1031 exchange and maintain tax deferral, it is critical to work with a 1031 exchange expert to ensure that you meet all pertinent requirements.
For taxpayers who do not plan to conduct a subsequent 1031 exchange (and who do not have other viable estate planning or tax planning strategies available), it will be crucial to consider the timing of the sale of their replacement property strategically. For example, if you know that your taxable income will be significantly lower next year than it is this year, then it may make sense to wait to sell your replacement property. On the other hand, if you have capital losses that you have carried over from previous tax years, then this may not be an issue.
There are numerous other permutations as well. Ultimately, you will need to make informed and strategic decisions based on your specific financial circumstances. An experienced 1031 exchange expert can help, and to make sure you do not lose opportunities to defer (or reduce) your capital gains tax liability, you should take a proactive approach with your long-term goals in mind.
Discuss Your Options with a 1031 Exchange Expert for Free
Would you like to speak with an experienced 1031 exchange expert? If so, we invite you to get in touch with us. We work with business owners and real estate investors across the nation. To schedule a free consultation with one of our 1031 exchange experts as soon as possible, give us a call at 888-872-1031 or tell us how we can help online today.