The combination of deferred income tax provisions on real property exchanges combined with effective planning with the continuing provision for death basis step-up, permit profits in real estate in properly structured transactions to escape taxation in perpetuity. A like kind, or tax deferred exchange as such transactions are commonly known, can override the general rule that a sale or exchange of real property is a taxable event. That is to say, if a taxpayer enters into a like-kind exchange whereby he or she exchanges one property held for business or investment for another property of like-kind the taxpayer is able to defer recognition of gain or loss.
The theory behind the like-kind exchange rule is that the replacement property, in substance, is merely a continuation of the old investment because, in the eyes of the IRS, there has been no liquidation. That said the law provides for no current recognition of gain or loss.
To preserve the unrecognized gain, the Internal Revenue Code requires that the basis of the old property carry-over into the new target or replacement property. The holding period “tacks” on to the new property so that the accrual of time of ownership in the relinquished property renders the newly acquired property eligible or nearer to eligibility for lower tax rates on long-term capital gains.
While of course some exchanges are just that – swapping of two properties between two owners, most exchanges are really a “fiction” in the sense that Party A sells his property, “Whiteacre”, to party B, and then acquires another parcel from Party C. Moreover, the actual or fictive exchange need not be simultaneous. That said the Code contains strict time limits for qualification of a non-simultaneous exchange. Among other requirements, the taxpayer must identify the replacement property within 45 days after the date of the transfer of the relinquished property and must acquire the replacement property by the earlier of 180 days after the date the former property was relinquished, or the due date of the tax payer’s income tax return for the year in which the transaction occurred.
The Treasury Regulations do recognize that real estate transactions can and do fall apart. Accordingly, taxpayers are not penalized for identifying more than one replacement property as long as they do so within the above-described 45 day identification period. Taxpayers may identify up to three properties without regard to fair market value (the “3-property rule”), or any number of properties as long as their aggregate fair market values does not exceed 200% of the aggregate fair market value of the relinquished properties (the “200% rule”). The Regulations permit a taxpayer to timely revoke an identification of a property as a replacement property if the revocation is affected by amendment to the original written document and filed before the end of the revocation period with the parties who received the original identification.
Most real estate professionals are aware of the requirement that the replacement parcel(s) must be at least of value equivalent to the relinquished property to avoid partial or comprehensive recognition of income tax on gain realized. Some, however, are not aware of the rule of “boot”. Debt paid off in the sale of the relinquished property is considered receipt of taxable boot which will cause a portion or indeed all of the gain realized on the deal to become currently taxable unless secured indebtedness is undertaken in regard to the newly acquired property. Stated differently, the new indebtedness is netted against and offsets the above-described boot received in the transaction. Realized gain is recognized, up to the whole thereof, to the extent of any deficiency in boot netting.
Partial taxable gain may also accrue when personal property, such as furniture and furnishings, are included in the transaction, but not fixtures, i.e., that which would otherwise have constituted personal property but for the fact that it is so affixed to the real estate or wrought into the property that removal would cause a measurable diminution in value of the property or impracticability.
Another well known requirement is the mandatory use of an “accommodator”; essentially a straw person to custody the proceeds of the sale pending their reinvestment. This express requirement avoids taxation cause by what is known as “constructive receipt.” Certain of our clients have moved through ownership of 4 or five properties in a lifetime without recognizing any taxable gain or liability. Because heirs of taxpayers continue to enjoy a step-up of cost basis on death, the “deferred” gain in the property is effectively forgiven, meaning that children taking title through their parents can turn around and sell an inherited property which is the fruit of one or more tax deferred exchanges one day after their parent’s death and pay no income tax on such transaction or, alternatively, can maintain the property and receive a new depreciable basis at fair market value.
The combination of tax deferral and step-up renders property transactions properly planned for effectively tax exempt. Few other provisions of the Internal Revenue Code individually or in concert can compare with the economic benefits of a Section 1031 exchange. What should be evident from this discussion are the significant economic benefits of qualifying eligible transactions as Section 1031 exchanges. However, given that even small missteps can trigger a federal and state income tax disaster, it is important to work with an experienced tax/real estate attorney to backstop any issues. The parameters are tight and unforgiving. The Service does scrutinize 1031 transactions very carefully, looking for disqualifying features. The cost of protecting the transaction from errors using qualified counsel far outweighs the risk of implosion under successful IRS scrutiny.
Should you have any questions about this process we invite you to contact our office.
The above information is provided for general information purposes only, and does not constitute legal advice. Successful implementation of the above-described techniques requires careful consideration of facts particular and unique to
The above information is provided for general information purposes only, and does not constitute legal advice. Successful implementation of the above-described techniques requires careful consideration of facts particular and unique to each situation and, therefore, should only be considered after a detailed consultation with an attorney. The above information is not intended to create an attorney-client relationship between the Law Offices of Daniel D. Kopman/Kopman Law and the reader. Such relationship would only arise, if at all, upon negotiation and execution of a written fee agreement.