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As in any normal buying and selling activity, many times the sale of capital assets such as bonds, stocks, or real estate result in profits. In more specific terms this profit is called capital gains. As a rule, any capital gains realized from the sale of a capital asset is therefore subject to capital gains taxes. Different countries have different rules or tax rates in imposing the capital gains taxes; some countries may not even impose such. To provide incentive and to promote investment deals, some relief and exemptions are granted to sellers through the 1031 exchange. The 1031 Exchange is a form of tax deferral involving the sale of a capital asset in order to buy another capital asset that is basically of the same “kind.” Hence the following are points of consideration in determining eligibility for exemption under the 1031 Exchange: The capital assets sold and bought must be “like-kind.” “Like-kind” refers to the type of property. A “like-kind” exchange means relinquishing of property held for investment in exchange for a property also intended for investment; this may involve a property held for rental business relinquished in exchange for a property also held for rental business. Mainly it means you have to exchange real estate for real estate and can’t apply gains from a real estate investment to purchase of other types of possessions for investment The aggregate purchase price of the capital asset to be acquired must equal or exceed the selling price of the capital asset to be relinquished. Hence the exchange technically results in off-setting what you were supposed to gain from the sale of the first because of the mark-up of the purchase price of the “more valuable” capital asset you acquired. The entire proceeds from the capital asset relinquished shall be applied as payment for the new property being acquired. Hence, if the proceeds realized from the relinquishment are less, additional funds have to be contributed to push through with the actual exchange.
So technically no actual capital gain subject to capital gains taxes was realized, since you either received an equivalent amount or shelled-out additional funds. If the transaction simply involves buying and selling but there is the excess income after purchase of the second property, this amount will be subject to capital gains taxes. So what happens if certain requirements of 1031 exchanges are circumvented? The amount of capital gains taxes may range between 20-30 percent of the income gained or more, depending on the federal and state tax rates prescribed. Furthermore, any violation or deviation in the application of the 1031 exchange will subject the violator to penalties and surcharges. The end result therefore is a greater amount of tax due. So be sure to know and follow the 1031 guidelines, if you decide to go this route, and be sure that the second investment property is expensive enough to absorb the entire amount gained from the first property, to take full advantage of the capital gains tax deferment.
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