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The Tax Deferred Exchange Legal Tax Angles: How to Save Taxes Without Going to Jail Tax code section 1031 permits taxpayers to defer the realization of any taxable gain on certain types of assets that are exchanged for assets of a "like-kind." As a practical matter, the tax deferred exchange (also often called a tax free exchange) is most often used with real property rather than with personal property. With real estate, the definition of like-kind property is extremely broad whereas with tangible personal property, the definition of like-kind property is extremely limited and restrictive. With respect to property in the form of securities or security interests, the section 1031 rules do not apply. When your appreciated real estate reaches the point where there is a need to sell, you may be able to defer taxes even longer with a tax deferred exchange. For example, raw land that has increased greatly in value might be exchanged for an apartment building or office building that is fully developed and generating cash flow. A factory building might be exchanged for raw land or for a shopping center. The tax deferred exchange is usually better than selling the property, paying the tax and then reinvesting in a different kind of real estate. But it won't help to avoid taxes on appreciated assets that are being sold and reinvested in different types of investments or not being reinvested at all. The alternative to a tax deferred exchange is to sell the property, pay the capital gains tax and then reinvest the after tax proceeds in some other investment. If the money were reinvested in other depreciable real estate, the new real estate can be depreciated, thereby reducing your current income taxes. The problem with this concept is that the loss of asset value and earning power is greater than the tax savings, unless the old property was not earning any income or not growing in value. Some capital gains taxes may be due on a tax deferred exchange to the extent of any “boot” received in the exchange. That includes the assumption of a mortgage by the other party to the exchange or a payment of cash (or other property) to equalize the values of the exchanged properties. ("Boot" basically means an amount other than real property received in excess of the value of the property that is given up.) The tax basis (cost) of the property received is equal to the basis of the property given, adjusted for the effect of any “boot” received or paid. If you enter into a tax free exchange with a related person and if that person disposes of the property within two years after the exchange, you may be subject to taxes on the deferred gain. For this purpose, a “related person” includes parents, children, siblings, a spouse and entities controlled by the taxpayer - including partnerships in which the taxpayer has a 50% interest. A tax deferred exchange of real estate usually requires the help of a real estate broker who is a specialist in such exchanges. The property you exchange must be held for “productive use in a trade or business or for investment”. It must be exchanged for property that is of a “like kind”. Vern Jacobs Copyright, 2003 |
Books and Services by Vern Jacobs
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