Article-How the 1031 Exchange Opportunity Keeps IRS, State and Local Tax Authorities out of your Client's Pockets

How the 1031 Exchange Opportunity Keeps IRS, State and Local Tax Authorities out of your Client's Pockets
by Marilee Hill, MA Hill Brokers

A 1031 Exchange is a transaction in which a taxpayer is allowed to sell one property and buy another without a present tax consequence. The transaction is authorized by Section 1031 of the IRS Code. It is the best strategy for the deferral of capital gains tax that would ordinarily arise from the sale of real property.

In 1997, we had a reduction in the capital gains rate. It also changed depreciation taken on real estate from the capital gains rate to the personal property depreciation recapture rate, usually 25%. In Maryland there is no capital gains tax rate, the capital gains portion is taxed as ordinary income, usually a combined 8% for all jurisdictions.

Taxation of an Outright Sale;

Sale Price (Net)$1,000,000
Mortgage$500,000
Net Cash Received$500,000
Original Purchase Price$300,000
Depreciated Basis$100,000
Capital Gain$700,000
Federal (20%) and State Taxes (8%)$196 000
Gain from Depreciation$200,000
Federal (25%) and State Taxes (8%)$66,000
Combined Tax Owed$262,000
Cash for Reinvestment$238,000

No matter how you cut it, when you sell an investment property outright you will pay through the nose. Some of your clients cannot afford to sell because the taxes and the mortgage indebtedness would exceed the cash coming from the sale.

A 1031 exchange will keep the IRS and the State of Maryland out of your client's pockets and he will be able to reinvest $500,000 instead of $238,000. To do this, your client:

  1. Arranges for the sale of his property and either includes 1031 exchange language in his contract or before settlement notifies the purchaser of his intent to exchange.
  2. At closing directs proceeds to go to a Qualified Intermediary.
  3. Within 45 days identifies up to three potential exchange properties.
  4. Closes on one or more of the three identified properties within an additional 135 days (180 days total).

Under the 1031 exchange rules your client can choose to "bundle" properties. He can sell two properties and exchange the proceeds for one property. The sale of his first property determines his time limits for both.

To the extent that your client does not exchange even or up and/or exchange even or up in equity and debt, he will receive nonqualified property ("boot") in his exchange. If he receives boot, tax is owed on the amount of gain on the sale or the amount of boot received, whichever is lower. As indicated by up, your client can always add cash to the new investment or incur greater debt.

To effect a 1031 exchange your client must exchange for a Like-Kind property. In 1991, the IRS clarified what Like-Kind is. Your client can exchange any real estate investment for any other type of real estate investment. To state the extremes, vacant land can be exchanged for a high rise office building and vice versa. To complete the exchange he must never touch any of the cash held by the Qualified Intermediary and in settling on his identified property he must receive a deed in fee simple.

An often overlooked candidate for a 1031 exchange is the small business owner selling a business that owns substantial real estate. Sam and Jenny Jones over 24 years have built up an antique concession business. They plan to sell their business and use the proceeds for retirement income. The building and grounds in which the concessions operate are the business's main asset. They sell for $2,000,000. With a 1031 exchange Sam and Jenny can have more fun in their retirement by receiving income from the reinvested $2,000,000 instead of the $1,476,000 left over to invest after paying the tax due from an outright sale.

Others in this overlooked category are garden centers owners, businesses with warehouses, businesses run out of commercial townhouses and, of course, the family farmer. To determine what amount of the sale the farmer can exchange he has an appraiser determine the value of the family home and surrounding yard and subtracts that value from the sale price.

Most people forget that by deferring tax in a 1031 exchange Sam and Jenny avoided losing all the future earnings of the tax forever. For every $100,000 of tax, at 10% potential net return on investment, Sam and Jenny and their heirs avoided losing $10,000 each year on each $100,000. In other words, over the next twenty years they would have lost a total of $672,750, for every $100,000 of tax paid, if they had chosen to pay the tax.

Ultimately, when Sam and Jenny die, their heirs will inherit the property with a step up in basis. Uncle Sam and Aunt Maryland should never receive any tax from the deferred capital gains. YES! The estate will be worth more and there will be more estate tax to pay. However, heirs receive more after 55% of $4,000,000 is paid than after 40% of $2,000,000 is paid!