Deferring Taxes with an IRC Section 1031 Exchange
Ah, the sweet promisors of tax avoidance: Sell what you have, they cry, buy what I have (or pay me a fee for service) and never pay tax on your gain!
Buyer beware, I say. Like all good hustles it’s the kernel of truth in this one that makes it so enticing. But certain rules always apply. To make money you have to:
- Buy low
- Sell high
- Pay tax on the gain.
With a like-kind exchange (authorized by Internal Revenue Code §1031) the question isn’t whether tax will be paid, only when. And while tax deferral is generally a good thing obviously it’s a far cry from tax avoidance. Here’s how a like-kind exchange is meant to work.
Suppose that ten years ago an investor bought an apartment building in an up and coming Boston neighborhood for a million dollars. Today, it’s worth three million and our lucky investor wants to sell and reap his reward. Naturally, he’d like to avoid step three of our money-making algorithm and avoid the tax on his two million dollar gain. Can he do so?
Of course not. But if he’s willing to reinvest his gain quickly, and do so in a particular way, he can delay paying the tax until later. For example, perhaps our investor wants to repeat his process of buying real property in a dicey neighborhood, adding value and stability to it in the process, and then selling when things improve.
Now in addition suppose that a different investor prefers to operate rental properties in fully developed neighborhoods. Unfortunately for this other investor, the apartment building he presently owns is in a neighborhood that has sadly gone downhill. For the moment, at least, this second investor’s building is still worth more than he paid for it.
If each investor sold what they had the tax on the gains would reduce their available capital for reinvestment. But since each wants what the other owns these two investors might agree instead to swap ownership of their buildings and even out any differences in value by trading cash and loan repayment obligations on the side.
This is the essence of the like-kind exchange. Each investor takes his new property and keeps the basis he had in the old property. So if our original investor repeats his good fortune and this newly acquired building is one day sold for say, five million, he will have to pay tax on a four million dollar gain, i.e., the difference between the second building’s value at the time of sale and what he paid for the first building (with, maybe, a few other adjustments).
This is tax deferral and it’s good. It allows both investors to take full investment advantage of their built-in gains. But if someone tells you that you’ll never have to pay tax on your gain…run far, run fast.
There are numerous traps for the unwary in this process, too. For instance, the items exchanged must be sufficiently similar (hence the name “like-kind”) so real estate for real estate usually qualifies. But wait – if one property in inside the United States and another is outside then a §1031 exchange is not allowed. Personal use property, like vacation homes, are out, too, as are inventory and stocks, bonds, and notes. If you trade one farm animal for another you’ll only get like-kind exchange treatment if they’re the same gender (not sure who thought that one up…bulls don’t give milk, I suppose). Cars are not like-kind to trucks, either. And on and on it goes.
Even if the properties exchanged qualify for like-kind treatment you still have to be careful how the transaction is done. For example, if our original investor had sold his building, held the cash for even a day, and then paid the cash over to the second investor for his building, the tax would have been immediately due unless he took precautions such as using a “qualified intermediary” and the deal was ultimately concluded in keeping with specific timelines laid out by the IRS.
So if you get an email in your inbox one day from someone offering to unload some of your investment property for a tax-free gain now you know what to do. Pressing the delete button is a good idea. After that, if you still want to move that property at least give your tax advisor a call before doing anything.
This article is for informational purposes only and does not constitute legal advice. You should consult a qualified attorney before taking any action.