Tax Deferred Exchanges in Theory

June 22, 2015|Kenneth Zacharias

A tax deferred exchange is simply a method by which a property owner trades one property for another without having to pay any federal income taxes on the transaction. In an ordinary sale transaction, the property owner is taxed on any gain realized by the sale of the property. In an exchange, the tax on the transaction is deferred until some time in the future, generally when the newly acquired property is sold.

These exchanges are sometimes called “tax free exchanges” because the exchange transaction itself is not taxed. Other common names are “like-kind exchanges” and “starker transactions.”

Tax deferred exchanges are authorized by Section 1031 of the Internal Revenue code. The requirements of Section 1031 and other sections must be carefully met, but when an exchange is done properly, the tax on the transaction may be deferred.

In an exchange, a property owner simply disposes of one property and acquires another property. The transaction must be structured in such a way that it is in fact an exchange of one property for another, rather than the taxable sale of one property and the purchase of another.

Today, a sale and a reinvestment in a replacement property are converted into an exchange by means of an exchange agreement and the services of a qualified intermediary – a fourth party who helps to ensure that the exchange is structured properly.

The IRS’s regulations make exchanging easy, inexpensive and safe.

Advantages

The primary advantage of a tax deferred exchange is that you may dispose of property without incurring any immediate tax liability. This allows you to keep the “earning power” of the deferred tax dollars working for you in another investment.

Under current law, this tax liability is forgiven upon your death. The heirs get a stepped-up basis on such inherited property; that is, their basis is the fair market value of the inherited property at that time.

Disadvantages

You should also consider the disadvantages of a tax deferred exchange. These include the following:

  1. There will be a reduced basis in the replacement property, resulting from the carry-over of the basis of the relinquished property. This means that the deferred gain will be realized when the replacement property is sold. You will also have lower depreciation deductions.
  2. There will be increased transactional costs for entering into and completing a tax deferred exchange. These costs include possible additional escrow fees, attorney’s fees, accounting fees and the intermediary’s and accommodation titleholder’s fees where applicable.
  3. You may not (without tax consequences) use any of the net proceeds from the disposition of the property for anything except reinvestment in real property.

Before deciding whether or not to engage in an exchange, carefully analyze all of your options. A decision should NOT be based solely on the tax consequences of the transaction. Rather, business considerations should play the dominant role in the decision. Business considerations include, but are not limited to the need or desire to:

  • Consolidate (or diversify) investments
  • Obtain greater appreciation of the real property
  • Increase cash flow
  • Relocate a business investment
  • Eliminate management problems.

Once all of the factors have been considered, you may or may not decide to engage in a tax deferred exchange.

If you have any questions regarding structuring such an exchange, contact Kenneth Zacharias at 920-455-4207, or ask for any member of the Schenck Real Estate & Construction team.


Kenneth Zacharias, CPA, has a broad background in income tax and general business consulting. He has extensive experience in taxation issues concerning real estate, including like-kind exchanges, use of partnerships and LLCs, construction and developer issues, and capital gains planning.