By: William L. Exeter President/CEO of Exeter 1031 Exchange Services, LLC.
Each month we review some of the common questions we receive about 1031 Exchanges. Your questions are always welcome. Submit them to us at email@example.com or by posting them to the Discussion Board at exeterboard.com.
WHEN IS A FAILED 1031 TAX DEFERRED EXCHANGE TAXABLE?
Q: I just sold an apartment property and my money is in a 1031 Exchange. I’m looking for property to exchange into, but I’m not sure that I’m going to be able to find and exchange into other property. If I can’t exchange into other property, do I owe the taxes for 2014 or 2015?
A: The sale of your multifamily property closed escrow during 2014, which means that your taxable gain was triggered (realized) in 2014. However, you have also entered into a 1031 Exchange in order to defer the payment of your tax liability. Your ability to complete your 1031 Exchange by acquiring replacement property allows you to defer the payment of your depreciation recapture taxes and your capital gain taxes into the future by deferring (carrying forward) your gain into the newly acquired replacement property. If you are not able to identify any potential replacement properties within the 45 calendar day identification period or acquire any of the identified properties during your 180 calendar day exchange period, your 1031 Exchange fails (becomes taxable) and you will recognize (pay tax) on the gain from the sale of your property.
You ask a very good question. If your 1031 Exchange transaction does in fact fail, when do you owe the depreciation recapture tax and capital gain tax (“taxable gain”) realized on the sale of your property? This is a difficult question to answer in a concise Q&A format as there are many variables that can affect the answer.
It is important to note that Section 1031 of the Internal Revenue Code (“IRC”) works in conjunction with Section 453 of the IRC (“Installment Sale Treatment”). This means that a 1031 Exchange is treated like an installment sale transaction (i.e. a seller carry back note) when the transaction fails.
The answer to your question depends on when (in what tax year) you have the “legal right” to receive your 1031 Exchange funds currently held by your Qualified Intermediary. Generally, you do not have the legal right to receive your 1031 Exchange funds from your Qualified Intermediary during the 180 calendar day exchange period if you have identified potential replacement property as part of your 1031 Exchange but cannot (or do not wish to) acquire any replacement property. You must wait until the 181st day after the close of your sale transaction before you have the legal right to have your Qualified Intermediary release your 1031 Exchange funds to you.
Therefore, if your 180th day lands in the following income tax year (i.e. in 2015) you do not have the legal right to receive the proceeds from your 1031 Exchange transaction until 2015. Your capital gain, and therefore your capital gain tax, is deferred into (is not taxable until) 2015 under Section 453 of the IRC. The fact that you are not allowed to receive your 1031 Exchange funds means that your failed 1031 Exchange is treated as an installment sale and not taxable until you have the legal right to receive the proceeds from your Qualified Intermediary.
Be careful here, because as with any installment sale transaction, your depreciation recapture, if any, is taxable in the year your sale transaction closed ( 2014 in your case) regardless of when your capital gain is taxable. You do have the right, should you so choose, to recognize all of the taxable gain in 2014 if you prefer. It is important that you review your specific transaction with your tax advisor because of the numerous “moving parts” involved here.
IS THERE REALLY A SALES TAX ON REAL ESTATE?
Q: This question has been raised many times recently. The question is always phrased a little differently, so I’m combining all of the questions that I have received and paraphrasing it into this one. ‘Is it true that there is now a sales tax on the sale of real estate?
A: I know a sales tax on real estate sounds absolutely ridiculous, but buried deep in the legislation that created Obamacare were some little-noticed new taxes that are now referred to as Medicare Surcharges. It is not technically a sales tax on real estate as many have described it, but effectively it can appear to be just that. It takes on this appearance as a sales tax because the sale of real estate can trigger the tax.
First, the bad news. It is a new income tax that may be triggered by the sale of real property. The new tax is effective for any sale that closed after December 31, 2012. So, if the sale of your real property did trigger this new Medicare Surcharge, which we will discuss below, your actual capital gain tax rate will effectively be increased by the amount of this new tax, or 3.8%.
Let me attempt to explain how the Medicare Surcharge actually works so that you can determine if it would affect you.
There are certain thresholds that must be met before the Medicare Surcharge kicks in, including the following:
Single taxpayers with Adjusted Gross Income (AGI) of less than $200,000 and married taxpayers with Adjusted Gross Income (AGI) of less than $250,000 do not have to worry about triggering this new Medicare Surcharge.
This 3.8% Medicare Surcharge does not apply to all types of income; it only applies to interest income, dividend income, capital gains (including capital gains from the sale of real estate), and passive income (including passive income from partnerships and S corporations in which the taxpayer did not materially participate).
Those taxpayers whose Adjusted Gross Income or AGI exceeds those thresholds referenced above should be concerned about the new Medicare Surcharges. The new tax only applies to income that exceeds the $200,000 or $250,000 Adjusted Gross Income or AGI thresholds.
There are other taxes that fall under the Medicare Surcharge, including a 0.9% additional Medicare tax on compensation of more than $200,000 for a single taxpayer or $250,000 for a married taxpayer, which is imposed on both wage income and self-employment income. You should consult with your tax advisor to determine if there are any other taxes.
Have 1031 Exchange or 1033 Exchange questions? We have answers. Go ahead, ask! Send your 1031 Exchange to questions to firstname.lastname@example.org.William L. Exeter is President/CEO of Exeter 1031 Exchange Services, LLC. He’s been in the fiduciary services industry since 1980, began specializing in real estate tax strategies in 1986 with a specialty emphasis in 1031 and 1033 Exchanges, Self-Directed IRAs, and Land Trusts. Bill has written and lectured extensively on 1031 and 1033 Exchanges, Self-Directed IRAs, and Land Trusts and is a frequent guest expert on San Diego Radio Shows “The Financial Advisors — Money Talk Radio Show” on AM 600 KOGO and on “Inside Business Radio Show” on AM 1000 KCEO. You can email your questions to email@example.com, call (866) 393-8370, fax to (866) 393-8371 or mail to 402 West Broadway, Suite 400, San Diego, CA 92101, exeter1031.com. We have Answers; Go Ahead, Ask!