The sale of commercial and other real estate held for business, trade or investment triggers significant tax consequences that the careful taxpayer must understand in order to make prudent decisions. A properly structured 1031 Exchange permits the seller to defer gains on the sale by purchasing another, qualifying property. The rules for 1031 Exchanges are strict, and it’s important to consult an attorney before selling to ensure that you qualify for the IRS “safe harbor” surrounding the 1031 Exchange. But done correctly, the tax savings can be significant.
Most individuals are aware of the capital gains tax due on the sale of investment real estate. Currently 15% at the federal level, this tax is also applied at the state and local level to the gain realized on the sale of real estate held for business, trade or investment. But there is another, and higher, tax that is also implicated on sale. The Internal Revenue Code permits owners of non-residential real estate to depreciate the property on a 39 year straight-line. At sale, this depreciation must be recaptured, if the property is sold at a profit greater than the depreciation realized, and the applicable rate is capped at the individual’s current tax rate, or 25%, whichever is lower. Effectively, most taxpayers will use the 25% figure. This can add a significant burden to the tax bill of a seller who has been properly depreciating property over the period of ownership.
It’s important to remember these tax considerations when structuring a sale. The safe harbor provided by a 1031 Exchange permits the taxpayer to defer taxes on gains and depreciation recapture indefinitely. And upon death, the taxpayer’s heirs may qualify for a “new basis at death” on the property. The election will depend on the size of the estate, but for most estates the heirs will elect to proceed under the 2011 IRS rules which permit a $5 million estate exemption in exchange for permitting heirs to take property at the current market value at the time of death. So an inheritance of a commercial property that was the result of a series of 1031 exchanges would not require the payment of the deferred tax gain. Rather, the heir would take the property at the fair market value at time of death, and pay only gains from that point to sale, and the whole process of gains deferral can start over for that new taxpayer!