1031 TAX CONSIDERATIONS
Asset Class;
For Federal Tax purposes, treatment of any asset, including commercial real estate, is determined by its classification by the Internal Revenue Code (IRC).
Basis of Classification;
How real estate is classified for tax purposes is based on the subjective intent of the owners toward the use of the property at the time of acquisition. The four classifications are:
1. Property held as a personal residence
a. There is no cost recovery
b. Taxable gain is recognized, but loss is not
c. Exchanges are not allowed, but tax treatment at time of sale is very favorable
2. Property held “For Sale” to Consumers (Inventory Property)
a. No cost recovery is allowed
b. Gains and Losses on sale are ordinary business income or expense
c. Tax-deferred exchanges are not allowed
d. Installment sale tax treatment is not allowed
Examples of property that would be treated as inventory;
· Strip Shopping Center being built to be sold upon substantial lease up
· Spec Office Building being built to be sold
· Vacant land parcel purchased with the intent of subdividing it into smaller lots held for sale to the public
· Build to Suit Industrial property being built to be sold
3. Property Held for use in Trade or Business (Section 1231)
a. Assets must be held for more than one year
b. The property is subject to allowance for cost recovery (Depreciation)
c. Gains and Losses on Section 1231 Properties are separately netted from gains and losses on investments in the other property types
d. Net Section 1231 Gains are long term Capital gains; gains are taxed at preferential tax rates
e. Net Section 1231 Losses are ordinary business losses
f. Qualifying Section 1231 Assets can be exchanged for qualifying Section 1231 or Section 1221 Assets in a Section 1031 Exchange.
Examples of Properties that would be treated as Section 1231 properties;
· Strip Shopping Center being purchased with the intent of a long term hold as a rental property
· Office building owned and occupied by a user
· Industrial Park developed with the intent of a long term hold
· Apartment Building held as a rental property
4. Property held as an investment (Capital Assets; Section 1221)
a. No cost recovery is allowed
b. Net gain or loss is a capital gain or loss. As such, any loss is limited to $3,000 per year when netted against ordinary income, but unlimited when netted against gains
c. Qualifying capital assets can be exchanged for qualifying Section 1221 of Section 1231 assets in a Section 1031 Exchange
Examples of properties that would be treated as Section 1221 properties;
· Vacant land parcel in the path of progress purchased with the intent of a long term hold so as to profit from appreciation
· Large land parcel purchased with less than 30 percent of original basis allocated to improvements
When Section 1231 activities result in a loss, the loss is called a Net Operating Loss (NOL). Annual NOL’s can be taken against all other types of income. They are not limited to $3,000 per year like Section 1221 losses. If in any year the NOLs exceed other income, the taxpayer is allowed to amend tax returns for the previous three years to use up the NOLs. After amending the returns, if there is unused NOLs, the taxpayer can carry them forward to be used in the future. |