Tax deferred exchanges -- the last great tax savings tool

Since the 1950s the tax-deferred exchanges have been used to structure creative real estate transactions. The nontaxable exchange of real estate, sanctioned by Section 1031 of the Internal Revenue Code, may be the last great tax savings tool still available to all property owners.

The applications of this technique are nearly endless. Tax deferred exchanges can be structured for the transfer of commercial, income, investment and personal residences. The significant benefit arises with the capital gain on these properties, normally due upon sale, being deferred (delayed) into another property.

What is a tax deferred exchange?

A tax deferred exchange is simply a method by which a property owner may trade one property for another without having to pay any federal income taxes on the transaction. In an ordinary sale transaction, the property owner is taxed on any gain realized by the sale of the property. But in an exchange, some or all of the tax on the transaction is deferred until some time in the future, usually until the newly acquired property is sold. These exchanges are sometimes called tax-free exchanges, because the exchange transaction itself is only partially taxed, or not taxed at all.

Internal Revenue Code Section 1031 provides that no gain or loss will be recognized on the exchange of any type of business use or investment property for any other business use or investment property. But 1031 Exchanges are not really exchanges in the context of two-party barter. Instead, they are typical sales and purchases that involve the same exact ingredients as any other sale or purchase, but without the capital gains. The real difference is the investor is boosting his selling and buying power by electing to legally avoid the drain of taxes by using Section 1031 regulations.

Exchanges are granted authority under Section 1031 of the Internal Revenue Code (IRC 1031) and the Regulations promulgated thereunder. When an exchange is conducted in accordance with the code and the regulations, the tax on the gain, which is realized by virtue of the sale of the old property, will be deferred (not recognized) until such time as the property acquired in the exchange is sold or otherwise disposed of in a subsequent taxable transaction.

Simply put, in an exchange, a property owner simply transfers the old property and receives the new property. However, the exchange must be structured in such a way that it is, in fact, an exchange of one property for another, rather than the sale of one property and the purchase of another.

A taxpayer is deemed to have sold property in a taxable transaction if the rights and interests in the property are conveyed and the taxpayer is in actual or constructive receipt of the proceeds. Consequently, a taxpayer who transfers title to property to the buyer and walks the proceeds across the street to purchase the new property, is deemed to have sold the property in a taxable transaction and will be denied the benefits afforded of an tax deferred exchange.

But the taxpayer avoids such a taxable sale and purchase and qualifies for exchange treatment if, prior to the sale of the old property, the taxpayer enters into an exchange agreement with a qualified intermediary, a fourth party principal who helps to ensure that the exchange is structured properly and meets all of the requirements of the code and the regulations, and pursuant to the exchange agreement, assigns all of his or her rights in and to the sale agreement to the intermediary.

Common misconceptions about 1031 Exchanges

Misconception #1: Many still believe that the subject properties must be "swapped." Although this was required in the original code, this is rarely done in present times. Section 1031 Exchange regulations now enable one to sell their property to someone totally unrelated to the person from whom they are purchasing a replacement property.

Misconception #2: Many also believe only investors of large commercial properties can utilize the benefits of Section 1031. But the great thing about 1031 exchange regulations is that they apply to all investment properties, both large and small. Thus, they work the exactly the same way for a corporation selling a large shopping center as they do for an individual selling a single family home used as a rental property.

Misconception #3: Many believe they must acquire a property of "similar use or service." While 1031 exchanges are also known as "like-kind" exchanges, like-kind simply applies to real property held for business use or investment. Therefore, an investor may sell raw land and acquire a five-unit apartment building, or sell a warehouse and acquire raw land. He or she can sell one property and acquire three, or sell four and acquire one. Therefore, virtually any type of real property used for business use or investment will qualify.

Misconception #4: Many others believe 1031 Exchanges are very complicated and not worth doing. The fact is that when working with a qualified intermediary who specializes in Section 1031 tax deferred exchanges, the exchange process is relatively simple. The intermediary will keep you aware of your time deadlines and ensure you do everything in strict compliance with IRS regulations.

In next month's article, we'll look at the requirements of a 1031 Exchange and the parties and properties involved. See you next time around.

Note: This article is distributed with the understanding that the author is not engaged in rendering legal or accounting services and the information presented is not necessarily a complete summary of all materials on the subject. If legal, accounting, or other advice, or other expert assistance is required the services of a competent professional should be sought. Please keep in mind that the subject matter contained herein is constantly changing.

Robert E Bunn is an acquisition and management consultant in Cape Girardeau. (573-335-3351 or email at rbunn@igateway.net