Nontaxable exchanges of real estate give taxpayers an alternative to taxable dispositions and can provide federal income tax benefits. When a taxpayer considers disposing of real estate either used in a trade or business or held for investment, the nontaxable exchange provisions of Internal Revenue Code Section 1031 provide a beneficial means of acquiring a similar property in exchange for an existing property with little or no tax liability (see the example below).
The obvious benefit from a nontaxable like-kind exchange is that the taxpayer defers tax, and thereby has use of the tax savings, until such time as the replacement property is sold. If the taxpayer holds the replacement property until death, he or she has received a permanent deferral of the tax liability because of the current (2012) step-up-of-basis-at-death rules.
Nontaxable like-kind exchanges should be considered in any of the following situations:
- When a taxpayer intends to replace the real property with similar property.
- When the property being disposed of has appreciated in value so a sale would result in a significant tax liability.
- When a taxpayer has nondepreciable, nonincome-producing property and wants to obtain depreciable, income-producing property. This may be particularly beneficial for taxpayers needing additional after-tax income during retirement.
- When a taxpayer wants to convert from trade or business real property (e.g., active in management) to investment real property (e.g., triple net lease property), or vice versa.
Example: Using a like-kind exchange to generate retirement income.
Mary, age 63, has owned a 100-acre parcel of raw land for many years. The property is currently worth $1.5 million and her basis is $200,000. Mary wants to dispose of the property so she can use the proceeds to generate retirement income. If she sells the property, she will report a gain of $1.3 million and pay a tax of $195,000 (assuming a 15% long-term capital gains rate). She will invest her after-tax proceeds of $1,305,000 to yield 6%, so her annual pre-tax income from the investment will be $78,300.
Mary’s realtor helps her locate similarly-valued net leased warehouses generating an annual cash flow of 6%. If Mary enters into a like-kind exchange for the warehouses, she will not pay any tax on the disposition of her property and increase her annual income. If the warehouses yield 6% on $1.5 million, her annual pre-tax income increases to $90,000. By entering into a like-kind exchange, Mary will increase her pre-tax income by $11,700 ($90,000 – $78,300).
Like-kind exchange transactions are complex, and there may be valid reasons to recognize income rather than defer the gain. Please contact us to discuss the tax ramifications and economic benefits of a like-kind exchange or if you have questions on any other tax compliance or planning issues.