This is the first installment of a three-part series on Section 1031 like-kind exchanges. Part 1 explains WHY you should consider use of a Section 1031 like-kind exchange when selling commercial or investment real property. Part 2 covers the key rules for HOW to implement a Section 1031 like-kind exchange. Part 3 covers special issues applicable to a Section 1031 like-kind exchange when a Tenant-In-Common [TIC] interest is being acquired.
Why Consider a §1031 Like-Kind Exchange?
What if I told you that you could get a hefty 0% interest loan from the federal government to invest in commercial or industrial real estate? Would you be interested?
Still better yet, what if the terms of the loan provide that it may never have to be repaid? Are you interested now?
In effect,* that’s what a Section 1031 like-kind exchange can do for you.
Section 1031 of the Internal Revenue Code permits a taxpayer to dispose of property used in its trade or business or held for investment purposes without paying federal income taxes, including capital gains taxes, on any gain arising from the transaction. To qualify for nonrecognition of gain, the taxpayer disposing of the qualifying property must comply with the technical requirements of Section 1031 by exchanging the property for other like-kind property identified within 45 days after Closing, and acquiring the identified property within the time period provided by statute. In general, that time period is 180 days, but may be cut short if the taxpayer files its tax return for the period in which the Section 1031 like-kind exchange was initiated before the 180-day period expires. For real estate, “like-kind” generally means any other real estate, so long as it is acquired and held for use in your trade or business or for investment purposes. The key Section 1031 like-kind exchange rules are outlined later, in Part 2 of this series. This article addresses the advantages of a Section 1031 like-kind exchange.
To demonstrate the value of a Section 1031 like-kind exchange, let’s focus on the concept that a Section 1031 like-kind exchange permits you to dispose of qualifying property without being obligated to pay federal income taxes on any gain arising from the transaction. It works like this:
Scenario No. 1
Suppose you bought a parcel of vacant ground for $100,000, with the intent to use the parcel in your trade or business or simply to hold for investment purposes. A few years later, you decide to sell the parcel, which has risen in value to $300,000. Upon sale, you will have a taxable gain of $200,000.
Assume a federal capital gains tax rate of 20%. This is the current capital gains tax rate under the Internal Revenue Code.
At a 20% capital gains tax rate, the federal income tax payable in Scenario No. 1 is $40,000 (20% x $200,000 = $40,000). If you held the property free and clear, with no mortgage, you would be left with $260,000, which could, after payment of any applicable state taxes, be used to acquire another property ($300,000 sale price less $40,000 capital gains tax = $260,000).
States have their own taxes that may also be applicable. Illinois has a 5% flat tax on income. In Illinois, after applying the 20% federal capital gains tax rate and also applying the 5% Illinois flat tax rate, the effective rate on the gain is 25%. Accordingly, the effective tax on the $200,000 gain for an Illinois taxpayer would be $50,000, leaving only $250,000 available to reinvest. [Additionally, if that is not bad enough, you may also owe and additional 3.8% Medicare Surtax on net investment income.]
Scenario No. 2
Suppose instead of purchasing a parcel of vacant property, as assumed in Scenario No. 1, you bought a parcel of improved real estate. Suppose the purchase price was $500,000, with $100,000 allocated to the land and $400,000 allocated to building improvements. Ten years later, you sell the property for $700,000. During the ten-year period you owned the property, you deducted $100,000 as depreciation expense.
Although the property is sold for $200,000 more than your purchase price, the gain you realize is actually $300,000 because the $100,000 accumulated depreciation deduction reduces the property’s tax basis by a corresponding amount. As a consequence, although you purchased the property for $500,000, the current tax basis (after depreciation) is only $400,000. Therefore, the taxable gain is $300,000, calculated by deducting the tax basis from the sale price.
At first glance, you may believe that the effect of the foregoing is to increase your capital gain to $300,000 resulting in a federal capital gains tax of $60,000 (20% x $300,000 = $60,000); but that is not correct. Under current tax law, you are required to first pay a tax on an amount equal to the accumulated depreciation taken as a deduction on the property, at a depreciation-recapture tax rate of 25%, with the balance of the gain taxed at the 20% federal capital gains rate. [Once again, you may also owe an additional 3.8% Medicare Surtax on net investment income.]
As a consequence, the federal tax you will owe is (at least) $65,000, (25% x $100,000 depreciation-recapture tax = $25,000, plus 20% x $200,000 capital gain = $40,000, for a total federal tax of $65,000 – plus any additional 3.8% Medicare Surtax that may be applicable). If we once again assume for simplicity that you did not have a mortgage on the property, you would be left with $635,000 (or less) which, after payment of any applicable state tax on the gain, you could reinvest in another property. In Illinois you would pay an additional flat tax of $15,000 on the gain [$300,000 x 5% Illinois flat tax rate], leaving you only $620,000 (or less) to reinvest.
The Benefit of a Section 1031 Like-Kind Exchange
The beauty of a Section 1031 like-kind exchange is that the gain on the transactions described in Scenario No. 1 and Scenario No. 2 is not recognized at the time of sale, with the result that you do not have to pay either the federal capital gains tax or the federal depreciation-recapture tax [and, in Illinois, you do not have to pay the 5% state flat tax] on the transaction. Likewise, any applicable 3.8% Medicare Surtax would be deferred as well. Consequently, in Scenario No. 1, you will have the whole $300,000 to reinvest; and in Scenario No. 2, you will have the whole $700,000 to reinvest (once again, assuming no mortgage).
The capital gains taxes and the depreciation-recapture taxes are not waived by use of a Section 1031 like-kind exchange but, rather, the obligation to pay these taxes is deferred until a future transaction that results in a taxable event that recognizes a gain. [The same is true with the Illinois flat tax and the Medicare surtax.]
Since there is no prohibition against utilizing the Section 1031 like-kind exchange procedure in successive transactions, however, payment of taxes on the gain can be deferred indefinitely. If the taxpayer is a limited liability company, corporation, trust, or other entity with a perpetual existence, the day of reckoning for payment of the capital gains taxes and depreciation-recapture taxes [and state flat tax] may never come. You will, however, limit your depreciation deduction because the tax basis of the relinquished property will carry over as the tax basis of the replacement property. This tax basis can be adjusted upward if additional capital is contributed to acquire the replacement property or, thereafter, to improve the replacement property.
If the taxpayer/exchangor is a natural person rather than a limited liability company, corporation, trust, or other legal entity, the Internal Revenue Code provides that upon the death of the taxpayer/exchangor, the tax basis of all property owned by the taxpayer is adjusted to the property’s fair market value as of the date of death. As a consequence, no capital gains tax or depreciation-recapture taxes will ever be recognized on the prior exchanges. [In Illinois, the tax basis adjusts at death also, avoiding application of the state flat tax on the increase in value.]
It is these attributes that form the basis of my statement at the outset of this article that it is possible to, in effect, obtain a long-term loan* from the federal government, without interest, without scheduled periodic payments, without reflecting an outstanding liability on your credit report or balance sheet, and, possibly, with no obligation to ever repay.
[*As a fiscal conservative, I understand the argument that it is not actually like a “loan” because the money actually belongs to the taxpayer, not the government until taken via taxation. It may not be a perfect analogy, but you get the point.]
There are strict technical rules that apply to Section 1031 like-kind exchanges. Among them are technical rules for exchanging property subject to a mortgage. For this reason, advice from a knowledgeable tax adviser is critical when structuring a Section 1031 like-kind exchange. In Part 2 of this series, entitled Key Rules to Implementing a Section 1031 Like-Kind Exchange, we will review the basic rules that apply to carrying out a Section 1031 like-kind exchange to obtain its advantages.
As required by the Internal Revenue Service under Circular 230, you are advised that any U.S. federal tax advice contained in this article is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed in this article.