With stepped up commercial activity taking place in the Evansville region, more clients may be considering selling business or investment real estate. Frequently, clients hold onto property because they don’t want to recognize the capital gain, overlooking an easy opportunity to defer taxes. Exchanging like kind property under Internal Revenue Code section 1031 may put off recognizing taxable gain.
The beauty of these exchanges is that they defer the payment of tax, allowing sellers to use the dollars that would have gone to Uncle Sam to buy more real estate. Usually they are selling land or land and a building. With the proceeds, they can make another investment. If that investment is in another piece of real estate, they can defer tax. Sometimes that deferral can even be permanent. The exchange does not have to be for identical types of real estate. For example, a farm can be sold and replaced with other real estate, such as an apartment building, office building or “strip-mall” shopping center.
To achieve deferral of taxes under section 1031, three basic rules must be observed meticulously:
- The transaction must be structured as an exchange, not as a sale and re-purchase.
- Property must be like-kind. This is easy for real estate, but exchanges can apply to tangible personal property as well and the definitions are more difficult for personal property under the tax code.
- Property bought and sold must be used in trade or business or for investment purposes. Property held for sale, such as an inventory of homes in a subdivision, don’t qualify.
Purchases and sales don’t have to take place simultaneously. The mechanics of a non-simultaneous transaction, which requires funds to be held by a qualifying intermediary, must be handled with great care to come within the technical rules of the tax regulations. Within 45 days after the sale, a replacement parcel has to be identified and then acquired within 180 days. By careful adherence to the rules, the rewards of tax deferral can be significant.
The rules permit a great deal of flexibility if advance planning is done. For example, clients may convert one parcel of real property into several different types of replacement property (apartments, farm land, shopping centers and office buildings), increase income, finance to leverage broader ownership, improve quality, diversify geographic ownership, or whatever the needs may be. However, careful planning usually needs to take place before entering into a sales contract.
Like-kind exchanges are cost-effective for clients whose tax savings will exceed $6,000-$10,000. To have this level of tax savings, the capital gain on the sale property need only be $21,000 to $35,000. In a like-kind exchange, the taxpayer incurs additional transaction fees and additional intermediary fees which negate the benefit of tax deferral if the capital gain is less than $21,000.