The 1031 Exchange and Section 1231 Assets

Using Tax Strategies for Your Business

I discussed ways in which you can use deductions for real property in two newsletters; https://open.substack.com/pub/thefigrealestate/p/own-a-second-home?r=2l9z0y&utm_medium=ios and https://open.substack.com/pub/thefigrealestate/p/deductions-deductions-deductions?r=2l9z0y&utm_medium=ios

Another tax benefit commonly used for real estate is the 1031 exchange.

There are three categories taxable income falls under; ordinary income, capital gains and passive income.

Section 1231 assets fall into two categories, depending on whether a capital gain or loss is realized.

A Section 1231 asset is real or depreciable property, as defined in IRC 167, used in a trade or business for the production of income and held for more than a year (ie, long term). It’s not considered a capital asset.

Section 1231 properties include, but are not limited to, buildings, land and leaseholds that are at least a year old. Property held for the production of rental income is also considered property used in a trade or business.

Realized gains from the sale of a Section 1231 asset are treated as capital gains, while losses are treated as ordinary losses.

This is beneficial if you hold 1231 assets because the lower tax rates for long term capital gains apply and they avoid the $3,000 deduction limit on losses that apply to capital losses. Losses for a 1231 asset are deductible against income.

Long term capital gain tax rates are more favorable (0%, 15% and 20%) than ordinary income tax rates (there are seven tax brackets for ordinary income, with the highest rate of 37%).

Ordinary losses are not subject to the $3,000 loss limitation that apply to capital losses. Capital losses in excess of the capital gains may be deducted up to $3,000 in a taxable year and can be carried over indefinitely for succeeding years.

So what’s the catch?

Per the depreciation recapture rules, if you have a gain from a Section 1231 transaction, it’s considered ordinary income up to the amount of your nonrecaptured section 1231 losses from previous years. Any gain in excess of the recapture amount is Section 1231 gain. That is, the excess is long term capital gains.

Although sales or exchanges of Section 1231 property are a taxable event, Section 1031 provides that no gain or loss will be recognized when real property held for productive use in a trade or business or for investment is exchanged for like-kind real property.

A 1031 is an exchange of property of equal or greater value.

This is a tax -deferral technique. It allows you to use the proceeds for further reinvestment in other real property, as opposed to paying taxes now.

Essentially, it’s like borrowing from the government at a 0% interest rate. Instead of paying the government the taxes owed on the proceeds from the sale, you’re reinvesting that money in real estate.

Keep in mind, a 1031 exchange is mandatory if you meet all the requirements. You do not have the option to choose to defer or take the capital gain or loss in the tax year in which it was realized.

If you expect to have higher capital gains in the future, consider taking the capital gains now, in the present year, by not meeting all the requirements under IRC 1031.

Please consult with your accountant to discuss what’s most advantageous for your unique situation and needs.