In the financial world, capital refers to the things you own that have value. When you sell those things, you either make more than the original cost, sell for less than the original cost, and in rare instances, break even. This is a painfully simple explanation of the concept of a “capital gain” and a “capital loss.”
To determine what your capital gains are, you have to know what the IRS considers your “basis of assets” to be. The IRS defines that as: “generally the amount of your capital investment in property for tax purposes.” In other words, basis of assets are what you put into that investment to begin with, including initial costs, like the sales tax you paid on those assets. In the case of stock, the basis of assets would be the purchase price of those bonds, plus transfer fees and commissions.
What is less simple, and far more complicated is understanding under what conditions the IRS will tax those gains as a component of your income, and when you can claim an exemption. Unless you know those specific conditions, the IRS is highly unlikely to inform you that you actually don’t have to pay that amount in taxes. Here are a couple of those conditions.
If you sell a property or business, hopefully, you’ve come out with a gain. That gain is subject to a capital gains tax. But what if you’re reinvesting those gains?
In that case, under IRC section 1031, you’re eligible for a tax deferment.
At its core, a 1031 exchange protects an investor’s assets when he or she is using gains to reinvest. But, there are some restrictions and qualifications to constitute what would be called a “like kind” exchange, or an eligible reinvestment.
Both the property sold and the property you replace it with have to be used for trade and investment. That means the house you live in, your vacation home, a second home is not going to help you defer that tax liability.
You have 45 days from the initial sale to identify the replacement sale.
Here’s an important warning: don’t touch that investment money. If you take control of the cash before the exchange, your gains immediately become taxable. Some people ensure that they can maintain their eligibility by having an outside entity help them make that exchange, so that it’s certain that the exchange looks clean on paper.
On your paperwork, form 8824, you’ll be asked the following:
Who can do this?
To be eligible for a 1031 deferment, you have to make sure the property you’re investing in is “like kind.” The IRS doesn’t have a very specific language for that, so it’s been open to interpretation. Generally, you have to invest in something that is similar in nature to the previous asset you had. A home for a home, livestock for the same livestock, a business expense for a similar business expense.
There’s no limit as to how many times you can utilize a 1031. This deferment can be very powerful for your future gains. If those initial gains aren’t taxed, that means you have more to invest in your next asset. That means your returns are greater. Which gives you even more power on your next round of investment. In the matter of a decade, utilizing a 1031 can have helped you made tens of thousands of dollars in extra investment gains. While you will have to report your gains once you decide to cash out, overall, you’ll have made more money through your investments.
1031 exchanges cannot be done on a primary residence. But there is still a way to reduce your tax liability when it comes to your primary home.
Usually, if you sell the primary home that you live in, the gains you make in that exchange are a tax liable component of your income. However, you may be able to exclude a hefty portion of that from being counted as a part of your income, reducing your tax liability by up to $250,000.
Two things determine your eligibility: ownership and use.
You have to have owned and used your home as your main home for at least two out of the five years prior to its sale.
Generally, you can only claim one of these exceptions every two years. But if you are facing an expected circumstance, like the loss of the job or issues with your health, you may be able to qualify for a reduced exclusion amount.
Combining a 1031 Exchange and a 121 Exclusion is possible under some unique circumstances, typically when the primary residence has another type of residence attached to it. Think of a farmer’s home with farmland on it, or a duplex where the owner occupies only one of the units. It would take a fair bit of documentation and expertise, but the result could be considerable savings in tax liability.
Nuances like these can make a big difference in the amount you end up writing a check for every tax season. In the coming weeks we’ll be releasing more material regarding these and other important tax laws and regulations, so make sure to follow us on our social media accounts to stay up to date.