If you bought real estate years ago that has appreciated in value, you could be sitting on a king-size taxable gain when you finally sell the castle. Fortunately, there’s a way you might postpone the taxable gain until a time when you will pay a lower tax rate—or perhaps forever!
Strategy: Arrange for a tax-deferred “like-kind” exchange under Section 1031 of the Internal Revenue Code. Assuming you meet the tax law requirements, no tax is due until you sell the replacement property (the property you acquire in the like-kind exchange).
To top things off for high-income taxpayers, arranging for a deferred gain under the like-kind exchange rules may allow you to avoid or minimize the new 20% maximum federal tax rate on long-term gains and the new 3.8% Medicare surtax on investment income. However, you must pay strict attention to the tax law deadlines (see box below).
Here’s the whole story: Under Section 1031 of the tax code, you can defer a taxable gain if you exchange properties that are similar in nature, except to the extent you receive any “boot” as part of the transaction. Then you must pay current tax on the gain up to the amount of the boot.
The IRS takes a generous view of what constitutes “like-kind” property. For instance, you can swap a commercial building for raw land or an apartment building, or vice versa. But both the property being relinquished and the property being acquired must be investment or business property.
You can’t swap personal-use property on a tax-free basis.
Beginning in 2013, like-kind exchanges are even more valuable. For starters, a maximum 20% federal tax rate for long-term capital gain now applies to single filers with taxable income above $400,000 and joint filers above $450,000. The usual maximum rate is 15%. Plus, the new 3.8% Medicare surtax applies to the lesser of “net investment income” (NII) or the amount by which modified adjusted gross income (MAGI) exceeds $200,000 for single filers and $250,000 for joint filers.
Example: Suppose you bought a property years ago for $300,000 that is now worth $800,000. If you sell the property for $800,000 this year, you expect that the entire $500,000 gain will be subject to the maximum 20% capital gain and 3.8% Medicare surtax. Therefore, you’ll owe $119,000 in federal taxes (23.8% of $500,000). However, if you swap the property for like-kind property of equal value, your tax bill is zero.
If properties of differing values are exchanged, one of the parties may add boot—such as cash or other property—to the deal. When you’re the recipient of boot, you owe current tax on the amount, equal to the lesser of:
- The realized gain (i.e., the difference between the basis of the property being given up and the fair market value of what is received in exchange, including any boot)
- The fair market value of the boot. On the other hand, if you’re the one paying the boot, at least you won’t realize any taxable gain.
Tip: If you relinquish property with a larger mortgage than the mortgage on the replacement property, the difference is generally treated as taxable boot.
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