1031 Exchange: Frequently Asked Questions
Senior Vice President - National Counsel
Welcome to our short course on 1031 exchange practice.
This is for anyone wanting a basic understanding of tax-deferred exchanges of real property. Here you will find a description of common exchange procedures, a brief history explaining how modern exchange practice came to be, as well as laws and Regulations you need to know.
Why do a 1031 exchange, you may ask?
Here are some pros and cons:
Pro: Defer Payment of Taxes-Indefinitely-Without Penalty or Interest.
By doing a 1031 exchange, a taxpayer may dispose of "property held for productive use in a trade or business or for investment" (which we¹ll call "income or investment property"), and acquire replacement income or investment property, without recognition of capital gain in calculating the taxpayer¹s income tax. By avoiding recognition of capital gain, the taxpayer defers payment of income taxes, indefinitely at the taxpayer¹s discretion, without any penalty or interest coming due to the IRS or state tax authorities.
By deferring payment of taxes, the taxpayer has additional funds currently available for investment. The effect of this on a taxpayer¹s investment choices should be obvious, and will be discussed later.
Pro: Make Government an Investment Partner.
Really just a restatement of the first two points, but some folks think this says it best. By deferring payment of taxes, the taxpayer has use of "the government¹s money" to pursue personal income or investment goals.
Pro: Taxes Avoided by Death.
They say you can¹t take it with you, but here¹s how taxes deferred now can become taxes avoided forever. Under Internal Revenue Code § 1014, upon death all property in the decedent¹s estate is entitled to a stepped-up basis for purpose of calculating the heirs¹ capital gain upon a subsequent sale. Under this rule, property is valued as of the date of the decedent¹s death for purposes of determining its "basis,"without regard to when the property was originally acquired or its original basis. This allows an heir to avoid tax liability for all capital gains during a decedent¹s lifetime. While in some cases the benefits of this rule may be lessened by federal estate taxes or state inheritance taxes, potential for "stepped-up basis" is an important factor to be considered in anyone¹s estate or financial planning.
In sum, the 1031 exchange is an attractive vehicle for deferment of taxes, maximization of income, and accumulation of assets and wealth. This vehicle permits deferment of taxes until a later time, such as retirement, when the taxpayer may be subject to lower tax rates, or after death, when taxes may be avoided by the "stepped-up basis" rule.
So, what are the cons?
Con: Need Tax Advisor.
Each taxpayer¹s decision to do, or not to do, a 1031 exchange must be made in the context of his or her investment goals and overall estate plan. This decision begins with consideration of the taxpayer¹s current tax liabilities and potential capital gain upon sale of given property. Likewise, the decision must be made in light of the availability of suitable replacement property. Since these decisions may be complicated, and require technical or legal or accounting expertise, taxpayers are cautioned against attempting a 1031 exchange without the guidance of a knowledgeable tax advisor, such as a tax attorney or certified public accountant.
Con: Must Follow Rules and Regulations, and Meet Deadlines.
Current 1031 exchange practices have evolved from federal statutes and court decisions, culminating in Regulations issued by the IRS. These Regulations were written to strike a balance between the competing interests of taxpayer and tax collector, by establishing procedures, deadlines and protocols which, if observed, will cause the taxpayer¹s transactions to enjoy "nonrecognition" or tax-deferred status with the IRS.
Con: May be Increased Costs of Transaction.
As explained below, the taxpayer¹s observance of IRS Regulations in connection with the 1031 exchange will involve additional transaction costs. In addition to a tax advisor, the taxpayer typically will also need to retain an intermediary, an exchange escrow holder or trustee and, in many cases, an appraiser.
Motivation for doing a 1031 exchange is supplied by capital gains tax liability. The following graphs illustrate how a hypothetical taxpayer's capital gains tax might be calculated.
In this first example, our taxpayer acquired property 15 years ago for $800,000, making a down payment of $240,000 ("equity") and giving a purchase money mortgage for $560,000 ("debt").
Today, the property is being sold for $2,000,000. Mortgage payments have reduced the loan balance to $500,000. The taxpayer expects to receive $1,500,000 in cash from the sale.
In calculating his (or her) capital gain, we will assume the taxpayer has made no capital improvements during ownership and, therefore, the tax "basis" will be the acquisition price ($800,000). Subtracting $800,000 from the sale price of $2,000,000 yields a capital gain of $1,200,000. This capital gain is multiplied by the maximum federal capital gains tax rate of 20% to arrive at a tax due of $240,000.
Since the taxpayer expects to receive $1,500,000 in cash from the sale, his net sale proceeds (after payment of taxes) total $1,260,000.
Remember, this is a calculation of federal tax only. In many states additional taxes would be due to state authorities.
In our second example, the facts remain the same except the taxpayer has refinanced during his ownership, so that at the time of sale the mortgage loan balance is $1,700,000 (an 85% loan-to-value ratio). Now the taxpayer expects to receive $300,000 in cash from the sale. The capital gain and tax calculations remain the same, but because the taxpayer has much less equity his net sale proceeds (after payment if the tax due) total $60,000.
In this third example, the facts remain the same except that during his 15 years¹ ownership the taxpayer has both refinanced and claimed tax deductions totaling $260,000 for depreciation in value of improvements. The capital gain tax calculation remains the same, but now the taxpayer is also assessed for depreciation recapture at the rate of 25%, so the tax due is $305,000. Since the taxpayer expects to receive only $300,000 in cash from the sale, he will need additional cash ($5,000) to pay the federal tax due. So, like many taxpayers in real life, our hypothetical taxpayer must dig into his own pocket to sell his property and satisfy tax obligations at the same time.