Like many business owners, you might own highly appreciated business or investment real estate. Fortunately, there’s an effective tax and estate planning strategy at your disposal: the Section 1031 “like kind” exchange. It can help you defer capital gains taxes on appreciated property indefinitely, and even eliminate them permanently.
The exchange game
Sec. 1031 allows you to exchange one or more pieces of business or investment real estate for other business or investment real estate without recognizing capital gain. Despite the term “like-kind,” you can exchange an apartment complex for an office building, for example, or a farm for a strip mall. The only limitation is that the value of the new properties should be equal to or greater than the value of the existing properties. If you receive any cash or other non-real-estate property, it’ll be currently taxable.
Few Sec. 1031 exchanges involve a direct exchange of one property for another. Most are structured as “deferred exchanges.” In other words, you sell your property (the “relinquished” property) and then use the proceeds to acquire new property (the “replacement” property).
Safe harbors to be aware of
The key to avoiding capital gains tax in an exchange is to ensure that you never possess or control the sale proceeds. And the best way to do that is to use one of several IRS safe harbors. With a deferred exchange, you sell the relinquished property (or properties) and engage a qualified intermediary (QI) to hold the proceeds and buy replacement property (or properties). If you identify replacement property within 45 days and complete the purchase within 180 days after the relinquished property is sold, the capital gain is deferred.
With a reverse exchange, you engage a QI to acquire replacement property before you sell relinquished property. To defer capital gain, you must identify the relinquished property within 45 days and complete the sale within 180 days. To avoid holding title to relinquished and replacement properties at the same time, you must “park” replacement properties with an “exchange accommodation titleholder” until the transaction is completed.
These and other safe harbors (such as trusts and qualified escrow accounts) aren’t the only way to complete a Sec. 1031 exchange. But if you do an exchange outside the safe harbors, the IRS may challenge it and treat the transaction as taxable.
Harnessing the power of estate planning
Although a Sec. 1031 exchange is best known as a tax-deferral technique, it’s also a powerful estate planning tool. Ordinarily, when you sell appreciated real estate you must pay taxes on the gain at rates as high as 20%, leaving less to pass on to your children or other heirs.
If you hold onto property for life, however, the capital gains disappear. Your heirs receive a “stepped-up basis” in the property equal to its fair market value on your date of death, erasing any previous appreciation in value and allowing them to turn around and sell the property tax-free.
But what if you’d prefer to dispose of it in order to invest in income-producing real estate or to diversify your holdings? That’s where a Sec. 1031 exchange comes into play. Rather than selling property, paying capital gains taxes and reinvesting what’s left of the proceeds, an exchange allows you to accomplish your goals without losing any of the exchanged property’s value to taxes.
Exchanging properties for TIC interests
A tactic to consider is exchanging a single property for several tenancy-in-common (TIC) interests. TIC interests are fractional, undivided interests in larger properties. Exchanging real estate for TIC interests not only defers capital gains taxes, but also gives you access to professionally managed, institutional-grade real estate. And it provides some interesting estate planning opportunities.
Suppose Jim owns a highly appreciated apartment building. He wants to divide his estate equally among his children. But he’d prefer not to leave them the building jointly, for fear it’ll lead to conflict over whether to sell the building or hold onto it.
If Jim sells the building, he’ll be hit with a capital gains tax bill, leaving less for his kids. Instead, he opts for a Sec. 1031 exchange, trading the building for three equally valued TIC interests in a professionally managed real estate investment. When Jim dies, his children each receive a TIC interest with a stepped-up basis and can decide independently whether to sell or hold their interests.
Work with your tax advisor
When it comes to Sec. 1031 exchanges, you have multiple ways to exchange one or more pieces of business or investment real estate. Your tax advisor can help you structure things in the best way for your estate.