With capital gains taxes near historic lows, investors have begun to ponder if paying the capital gains taxes from the sale of their properties is a better option than rolling their sales proceeds into a new property via a 1031 tax-deferred exchange. Some believe that the difficulty of finding a suitable “like-kind” replacement property and the potential risk for paying a higher capital gains tax in the future outweigh the benefits of the tax-deferred exchange.  

The maximum capital gains rate assessed by the federal government is 15%. As recently as 1995, the capital gains rate was nearly double at 28%. So when does it make sense to participate in a tax-deferred 1031 exchange as opposed to selling and paying the government? Here are two factors to keep in mind when deciding whether a 1031 Exchange is appropriate for your situation. 

Recapture Tax: In addition to paying capital gains taxes, owners must pay a recapture tax of 25% on depreciation deductions already taken on an investment property. For example, if an owner purchased an apartment building for $1 million, took $200,000 of depreciation on the building and later sold the building for $1.5 million, then the total gain would be $700,000 (the building’s selling price of $1.5 million less its book value of $800,000). Of the total gain, $500,000 would be taxed at 15% and $200,000 (the amount the building depreciated) would be taxed at the recapture rate of 25%. 

Estate Planning: 1031 exchanges can turn into tax avoidance for an owner’s heirs. Should the owner die and the heirs sell the property, these capital gains taxes are usually wiped out.  According to Attorney Michael Tuchman, this is when deferral turns into permanent tax savings. “Upon death, the basis of the property gets  'stepped up' to fair market value and the capital gain is never taxed. Those who inherit the property can sell it at its fair market value and would not suffer tax on that gain.” Thus the strategy,  “swap ‘till you drop.”  While a 1031 exchange is a wise strategy for most owners, the best action is to speak to your tax advisor as soon your property is listed for sale.