Simple Application Of The IRS 1031 Exchange
Law
In a normal transaction of a property, the property owner
is taxed on any profit realized from the sale. However, through
a Section 1031 Exchange, the tax on the gain can be deferred
until some future date. As per Section 1031 of the Internal
Revenue Code, no gain or loss shall be recognized on the
exchange of property held
for productive use in a trade or business, or for
investment. This means that properties such as land, building,
vehicles, cattle etc. can be exchanged for another like-kind
property and defer taxes indefinitely. Because of such a
facility of deferring taxes, many companies opt for IRS 1031
exchange processes every year.
A tax-deferred exchange is a method by which a property
owner trades one or more relinquished properties for one or
more replacement properties of ""like-kind"", while deferring
the payment of federal income taxes and some state taxes on the
transaction. It must be clearly understood that the like-kind
exchange under Section 1031 is tax-deferred and not tax-free.
When the replacement
property is ultimately sold without any exchange the
original deferred gain and any additional gain realized since
the purchase of the replacement property, is subject to
tax.
One of the terminologies commonly used in the IRS 1031 exchange law is like-kind.
Like-kind indicates property type and not the property value.
In this, properties similar in nature only can be exchanged.
For example, exchanges are possible between independent
residential buildings to apartment buildings, vehicle to
vehicle, cattle to cattle etc. This obviously means that
building cannot be exchanged to vehicle; car cannot be
exchanged for land and so on and so forth. As indicated
earlier, there is no restriction on the value of the exchanged
property except that in case if the value of exchanged property
is less than the property sold it is considered as profit and
hence taxed. Hence, it is necessary that the exchange property
has to be of equal or higher value.
As per this law there is no problem in purchasing a higher
value property using
the sale proceeds of the original property. In such a case
there is no profit due to the sale of original property since
full amount of sale is utilized for purchase of a new property.
This means no tax is payable immediately on this sale. However,
this tax is deferred. The sale money can fully be utilized for
down payment to a new property which allows the person to
borrow further and purchase a better property.
A sample calculation for a normal transaction and
transaction based on IRS 1031
exchange law sale are given below.
Normal sale
Sale value of the original property - $100000 Normal tax
applicable on this sale - $35000 Net of tax amount on hand for
down payment - $65000 Down
payment made (Nett amount on hand) – 25% Loan eligibility -
$260000 Purchase Property value – $325000
IRS 1031 exchange law
sale
Sale value of the original property - $100000
IRS 1031 exchange law tax on this sale - $0 Net of tax amount
on hand for down payment - $100000 Down payment made (Nett
amount on hand) – 25% Loan eligibility - $400000 Purchase
Property value – $500000
The above figures indicate that you could purchase a
property worth $500000 using IRS 1031 exchange law sale against
$325000 for a normal sale. This means that there is an increase
in the property
value to the extent of $175000 and this would enable the
person to purchase a higher value property.
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