A 1031 is a provision in the IRS tax code that allows landowners to defer paying taxes on the exchange of property. When selling a property with the intent to purchase another, the capital gains remain untouched during the exchange, which is particularly beneficial for land investors.
However, despite the benefits derived from Section 1031, many landowners are unaware of how the filing process works or if they are eligible at all. That's when a certified land specialist from Mossy Oak Properties can help. With the proper guidance and industry knowledge to help owners capitalize on all the tax breaks available to them, MOP brokers can simplify the 1031 process and make each land exchange a painless experience.
Because most people aren't well-acquainted with the ins and outs of the federal tax code, it's important that owners receive the necessary help along the way. Here are a few frequently asked questions and some additional insight from leading MOP agents, including Raymond Grubbs, division manager of Mossy Oak Properties of Texas in Jacksonville, Texas and Kevin Teston, partner and broker at Mossy Oak Properties of Augusta in Augusta, Georgia.
Do I have to pay taxes in a 1031 scenario?
Grubbs stated a 1031 exchange transaction means no taxes are paid at the time. Simply put, owners are not required to pay an additional federal tax on the capital gains. The idea behind this is that the profits earned from one transaction can be used to invest in a new property. However, if this initial profit was taxed, there would be less incentive to purchase new land, specifically land of higher value.
"By using the exchange, the tax on the transaction is deferred to some point in the future, usually when the newly acquired property is sold," said Teston.
How are the taxes calculated and when do I pay them?
Taxes must eventually be paid if the property is sold instead of exchanged. Federal law mandates that the land being exchanged must be held for productive use for trade, business or investment. That's why a 1031 works well for investors because they are not looking to settle down and live on the land or sell the property outright.
On the other hand, if the land is sold, it would be taxed at the current capital gains tax rate.
"Taxes are paid only if and when you elect to sell, as opposed to exchange, your property," said Grubbs. "Currently, the taxes are calculated using the federal capital gains tax percentage - usually 20 to 25 percent of your gain - plus any state taxes."
Following the sale, taxes must be paid in that respective tax season.
Who do I need to engage when first considering a 1031?
As is the case with all tax proceedings, it's always best to leave it to the experts. To stay compliant with all state and federal laws, it's important that you properly apply for a 1031 credit.
"Competent legal and or accounting counsel is always recommended and should be engaged," Grubbs stated. "Tax laws are continually changing and IRC Section 1031 exchanges are often extremely complex or highly technical. These exchanges require guidance and answers to interpretive questions best left to legal or tax advisors."
Does a 1031 require properties to be similar in type?
A 1031 exchange hinges on the condition that the two properties are of like-kind.
"In order to qualify for a tax-deferred exchange under Section 1031, certain requirements must be met," said Teston. "First, it has to be qualified property, which in most cases will be real estate. The property must be held for investment, and there is a like-kind requirement, which means 'similar in nature or character, notwithstanding differences in grade or quality.'"
The two properties don't have to be of the same quality, just the same type, with a caveat being property inside the U.S. cannot be exchanged for land outside the U.S. tax-free.
How long do I have to find another property to declare for a 1031?
Once the initial property is transferred to a new owner, you have 45 days to identify the new property to be "exchanged." The 45-day window opens upon the closing of the previous sale and closes on the 45th calendar day.
There is a 180-day period for the new property to be purchased, which begins after the previous property is closed. The property that is identified during the first 45 days cannot be substituted for another after this period. After the 45-day identification period, you have an additional 135 days to successfully close on the new property to be eligible for the tax-free exchange.
Is a 1031 recommended?
A 1031 exchange has many restrictions and thus is only pertinent to investors. Standard landowners typically do not deal with Section 1031, thus this code is only recommended for a specific type of client.
"I would recommend the 1031 process for my investor clients," said Grubbs. "This is an opportunity for clients to improve their investment value of land and real estate through purchase, improvement and sale without the burden of taxes eating away their margin, and allowing them more purchasing dollars for the new property purchase."
By capitalizing on the appreciated value of a tract, investors can purchase an even larger, more valuable tract with their tax-free dollars - a key tool for investors, Teston stated.
It's important to note that Congress is currently debating the future status of Section 1031, with some lawmakers calling for serious changes to be made and others wanting it to be scrapped altogether, according to the Land Report. Any changes to the 1031 tax code will likely be included in a larger tax reform bill sometime in 2015. Though it's unclear just how much 1031 will be adjusted, if at all, it's vital that landowners stay up to date with the latest developments happening in Congress. An experienced land broker from Mossy Oak Properties can provide expert advice on the future of 1031s and whether you may benefit.
For additional information about 1031 exchanges, contact a representative from Mossy Oak Properties today.