Like-Kind Exchanges, also know by their nicknames, 1031s and 1035s, are well-know strategies to defer taxes when selling an asset by quickly using the funds to buy a like-kind replacement property. To put it in simpler terms, properties that have appreciated in value can often be exchanged for other like-kind properties without being subjected to capital gains taxes that the IRS would otherwise require you to pay at that time.
What are 1031 and 1035 Exchanges?
The nicknames, 1031s and 1035s, have an interesting origin. They refer to Title 26 of the United States Code, Section 1031 – Exchange of property held for productive use or investment, and Section 1035 – Certain exchanges of insurance policies. As an example, a person who has an apartment building as an investment will see the value of the property go up over time. That increase in value is called a capital gain. When you sell your property, the Capital Gains that have been building up over the years are taxed. However, if you sell your property and buy a similar asset within the rules of Section 1031, then you can avoid paying taxes at the time of those transactions. That lets you keep more money in your pocket so that you can buy a more valuable replacement property and keep your investment returns higher.
What Are The Benefits?
The most obvious benefit of the application of these exchanges is to defer taxes on the gains and to utilize the increased capital to further grow assets. For example, let’s assume that you purchased a rental property for $100,000 and sold it for $200,000. By following the rules of IRC1031, you could then re-deploy the entire $200,000 into a new rental property. If you do not follow the rules, then the gain ($200,000 – $100,000 =$100,000), would be subject to immediate taxes.
Structuring Transactions Not To Meet IRC 1031
In some instances, it may be more beneficial to structure a transaction so that you intentionally skip the benefits of a 1031 using a strategy that takes a longer view of the horizon and what your family’s overall tax profile should look like. A few such long-term reasons to want to pay the tax immediately may be to increase your basis in the property in order to take greater depreciations or, from the family estate planning perspective, to transfer property to the next generation in a way that eliminates future capital gain increases from your estate.
As an example, assume you purchased a commercial property for $100,000 and with a current fair market value of $200,000. Assuming no adjustments, your basis on this property would be $100,000. If you exchange this property for another property, your basis that would carry over would still be $100,000. However, if you chose to realize the gains instead of an exchange, your new basis would be $200,000, and you could now take larger deductions for depreciation.
Tom bought an apartment building in 2011 for $200K, therefore his tax basis in the property is also $200K. Today that property is worth $500K. If Tom sold it today without using a 1031 Exchange, he would owe taxes on a built-in capital gain of $300K in the property [Selling Price $500K – Tax Basis $200K].
If Tom buys a like-kind replacement property within 180 days, he could defer the taxes that he would otherwise immediately owe. The downside though, is that Tom’s basis in the new property he bought would still be his old basis of $200K. That gets carried over from the old property as a requirement of a 1031. That way, if Tom sells this new property in the future, the IRS makes sure he would be on the hook for however much it went up in value since he bought the second building and ALSO for the taxes he should have paid when he sold the first building.
Often times, it is better to pay the taxes on the first sale so that you can take advantage of having a higher tax basis. By having a higher tax basis, you can help your kids out by giving them shares of property in a way that reduces your own estate taxes and also the capital gains taxes that will start racking up in the future.
Let’s also assume that Tom’s stock portfolio has some losses in it and Tom has another investment property that he is losing money on. By avoiding 1031, Tom is able to clean up his overall investment portfolio, since any taxes he would have had to pay on selling the building would be offset by the deductions that come from selling the loser investments in his portfolio.
Finally, if Tom anticipates that his income tax rates will rise in the future, he may want to lock in the lower taxes today instead of paying up when his tax rate is higher.
When considering the disposition of assets, especially when a replacement is being contemplated, it is imperative that you weigh the impact and consequences of taxes associated with the transaction both today and, more importantly, in the future.