Save on Capital Gains Taxes with a Like Kind Exchange

An Overview on 1031 Exchanges

Internal Revenue Code § 1031:
“No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like-kind which is to be held either for productive use in a trade or business or for investment."

§ 1031 exchanges provide investors with one of the best tax strategies for preserving the value of an investment portfolio. By using an exchange the investor is able to defer the recognition of capital gain taxes that would otherwise be incurred on the sale of investment property. The investor can then use the entire amount of the equity to purchase substantially more replacement property. To qualify as an exchange the relinquished and replacement properties must be qualified "like-kind" properties and the transaction must be structured as an exchange. Using Investment Property Exchange Services, Inc. as the "Qualified Intermediary" will provide the investor with the necessary reciprocal transfer of properties to create the exchange and the "Safe Harbor" protection against actual and constructive receipt of the exchange funds as required by §1031.

Tax Benefits of Exchanges

Whether the investor's property is owned free and clear or encumbered, the benefits of a tax deferred exchange are significant. The tax dollars saved by doing an exchange can be utilized to purchase additional investment property. Compare a sale versus an exchange. Assume the following: ? Investor sells property with no debt for $1,000,000 ? Basis is $500,000 ? The property has been held in excess of 12 months ? Capital gain is $500,000 ($100,000 from recapture of depreciation deductions and $400,000 from appreciation in value) ? Current federal tax rate for an individual is 20% on appreciation and 25% on depreciation recapture (corporations are taxed at a higher rate) ? Investor's state tax rate is 9% (Federal deduction for state taxes is not included).

* (Assume 30% Down)

Result: The investor who exchanges is able to defer the capital gain tax and purchase replacement property worth $500,000 more than the investor who sells and reinvests with after-tax dollars.

Non-Tax Benefits of Exchanges

In addition to deferring the capital gain tax, tax-deferred exchanges provide the investor with a wide range of non-tax opportunities to suit the investor's portfolio:

• Reposition assets
• Change property types
• Increase leverage
• Increase depreciation deduction
• Reduce management obligations
• Provide for estate and retirement planning
• Allow for relocation
• Improve cash flow
• Achieve property consolidation or diversification
• Eliminate or create joint ownership
• Defer phantom gain on problem properties
• Construct improvements on a property

The Exchange Process

An exchange is rarely a swap of properties between two parties. Most exchanges, whether they are simultaneous or delayed, involve three parties: the investor (exchanger) who is doing the exchange, the buyer who is purchasing the exchanger's old (relinquished) property and the seller who is selling the exchanger a new (replacement) property. To create the exchange of assets and to obtain the benefit of the "Safe Harbor" protections of the tax code to prevent actual or constructive receipt of the exchange proceeds, which would disqualify the exchange treatment, prudent exchangers use the services of a "Qualified Intermediary,". The Qualified Intermediary becomes a fourth party principal in both simultaneous and delayed exchanges. As illustrated in the above diagram, the steps for completing an exchange are relatively simple.

• The exchanger signs a contract to sell a relinquished property to the buyer.
• The Qualified Intermediary is retained and the exchanger assigns the exchanger's rights in the sale contract to the Qualified Intermediary.
• At the closing of the relinquished property the exchange funds are wired to the Qualified Intermediary and the Qualified Intermediary instructs the settlement officer to transfer the deed directly from the exchanger to the buyer.
• The exchanger has a maximum of 180 days in the exchange period (or until the tax filing deadline, including extensions, for the year of the sale of the relinquished property), to acquire all replacement properties.
• Unless the exchanger can acquire all replacement property within the first 45 days from the close of the relinquished property, the exchanger must identify possible replacement properties in writing to the Qualified Intermediary within the 45-day identification period.
• The exchanger signs a contract to purchase the replacement property with the seller and the exchanger assigns the exchanger's rights in the purchase contract to the Qualified Intermediary.
• At the closing of the replacement property, the Qualified Intermediary wires the exchange funds to complete the exchange and the Qualified Intermediary instructs the settlement officer to transfer the deed directly from the seller to the exchanger.

Calculating the Capital Gain Tax

The gain, not the profit or equity, from the sale of investment property is subject to the combination of capital gain taxes and the tax on recapture of depreciation. It is possible for an investor to have little or no equity or profit upon sale and still owe capital gain taxes. Investors should consult with their tax or legal advisors prior to entering into an exchange. This formula is a guide to estimate the potential capital gain tax.

Capital Gains Calculation Sheet:

This information is not to be construed as legal and/or tax advice. Investors should have their transaction reviewed by their own legal and/or tax counsel.

Thanks to IPX1031 (Investment Property Exchange Services, Inc.)
Reprinted with permission: ©2002 Investment Property Exchange Services