What Are Capital Gains?

Generally speaking, capital gains are any profits generated from the sale of assets. Further, people often refer to Section Internal Revenue Code Section 1031 states that "no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held for productive use in a trade or business or for investment." 1031 Exchange s as Tax Deferred Exchanges or Tax-Free Exchanges. The key language of the statute says that “No gain or loss shall be recognized on the exchange of real property held for productive use in a trade or business or for investment if such real property is exchanged solely for real property of like kind which is to be held either for productive use in a trade or business or for investment.” On its face, the statute is a tool to defer capital gains taxes, not to avoid capital gains taxes.

What is Capital Gains Tax?

Capital gains tax is the tax that American taxpayers (both US citizens and non-citizens) pay on any profits (capital gains) generated from the sale of assets. Those assets include real estate, investments such as stocks, and businesses, among others. According to the IRS, those gains are to be considered taxable income. The IRS has different tax rates for capital gains based on the taxpayer’s income tax bracket, as well has how long the asset was held.

Are There Variations of Capital Gains Tax?

Assets that the taxpayer held for longer than one year result in long-term capital gains, while assets held for less than one year result in short-term capital gains. The Internal Revenue Code (IRC). The comprehensive set of tax laws created by the Internal Revenue Service (IRS). This code was enacted as Title 26 of the United States Code by Congress, and is sometimes also referred to as the Internal Revenue Title. The code is organized according to topic, and covers all relevant rules pertaining to income, gift, estate, sales, payroll and excise taxes. Internal Revenue Code treats short-term capital gains the same as any other ordinary income so that the tax rate is the same as your income tax rate. Long-term capital gains at more favorable rates, as shown below.

For 2022, the tax brackets look like this:

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How is Capital Gains Tax Calculated?

Generally speaking, if an asset is sold for more than its purchase price (it’s “cost basis”), there is a capital gain. On the other hand, if it is sold for less than it’s purchase price, there is a capital loss. But the Internal Revenue Code (IRC). The comprehensive set of tax laws created by the Internal Revenue Service (IRS). This code was enacted as Title 26 of the United States Code by Congress, and is sometimes also referred to as the Internal Revenue Title. The code is organized according to topic, and covers all relevant rules pertaining to income, gift, estate, sales, payroll and excise taxes. Internal Revenue Code makes things a little more complicated, and calculates gain or loss based on the asset’s “adjusted basis.” To arrive at the adjusted basis, the taxpayer will start with the cost basis, and then add the cost of capital improvements, and subtract any depreciation taken. Note that only improvements to real estate can be depreciated, and the value of the land itself never depreciates. Use our Depreciation Calculator. 

To determine the final capital gains tax burden, the taxpayer would start by calculating the adjusted basis as described above, and subtract that from the current sale price; the difference is the capital gain. If the asset was held for longer than one year, the gain would be taxed according to the last column in the table above. If the asset was held for less than one year, the gain would be taxed as ordinary income based on the third column. Use our Capital Gains Calculator.

How Does Section 1031 Help with Capital Gains Taxes

As noted above, Section 1031 provides that the gain on the exchange of an asset is not recognized in the year of the sale. Under the Internal Revenue Code (IRC). The comprehensive set of tax laws created by the Internal Revenue Service (IRS). This code was enacted as Title 26 of the United States Code by Congress, and is sometimes also referred to as the Internal Revenue Title. The code is organized according to topic, and covers all relevant rules pertaining to income, gift, estate, sales, payroll and excise taxes. Internal Revenue Code , those gains are deferred, and will only be recognized at a time in the future when there is a taxable sale rather than another exchange.

A taxpayer can structure a transaction as a 1031 exchange in 2022, exchange that asset in 2025, exchange again in 2030, exchange again in 2032, and so on. Doing so would continue to defer the gains that accumulate between each sale. If that taxpayer ultimately sells the final asset in 2040, all of the deferred gains from each of those intervening 1031 exchange would be recognized.

But if the taxpayer is going to pay taxes at the end anyway, why exchange in the first place? There are two primary reasons that the taxpayer would structure those exchanges and then ultimately sell in a taxable transaction. First is the time value of money. Simply stated, the time value of money is the concept that a dollar today is worth more than a dollar tomorrow. Ask yourself this – would you rather pay someone $10,000 today, or ten years from now? Most investors would rather pay in ten years rather than today, preferably never if possible. The second reason is that theoretically, a taxpayer will sell their last investment property later in life, perhaps when they have past their peak earning years and are in a lower tax bracket. A married couple reducing their income from $650,000 to $200,000 would see their capital gains rate drop from 20% to 15% - a 25% reduction in the tax rate.

Can Section 1031 be Used to Eliminate or Avoid Capital Gains Tax

Using the scenario above, a taxpayer structures a transaction as a 1031 exchange in 2022, exchanges that asset in 2025, exchanges again in 2030, and exchanges again in 2032, before dying in 2035. Based on the Internal Revenue Code (IRC). The comprehensive set of tax laws created by the Internal Revenue Service (IRS). This code was enacted as Title 26 of the United States Code by Congress, and is sometimes also referred to as the Internal Revenue Title. The code is organized according to topic, and covers all relevant rules pertaining to income, gift, estate, sales, payroll and excise taxes. Internal Revenue Code , that taxpayer’s heirs would inherit the final property at the fair market value as of the taxpayer’s death, receiving the property at a “stepped up basis.” The heirs do not need to worry about any accumulated depreciation or capital gains that a taxpayer had meticulously avoided through deferral, and they start with completely fresh basis. If the heirs were to sell the property shortly thereafter, there would be no capital gains to recognize.

By continuing to exchange throughout their life, this taxpayer successfully avoided all depreciation recapture and capital gains taxes. They effectively converted a tax deferred exchange into a tax-free exchange.

Section 1031 can be a powerful investment tool, and an incredibly useful estate planning tool. (“Exchangor" or "Exchanger") Individual or entity desiring an exchange. Taxpayer s are encouraged to seek the advice of competent tax and legal counsel before structuring any 1031 exchange.