Consider Tax-Saving Sec. 1031 Exchanges for Appreciated Real Property

Real estate values have surged in many areas. You might be considering selling an appreciated investment or business property that you think has topped out. But an outright sale would result in a current income tax hit. If you plan to reinvest the sales proceeds from your current property in another property, a Section 1031 exchange allows you to completely or partially defer your federal tax obligation from the sale.  Here's how this valuable tax break works.

Favorable IRS Regulations

To qualify for Sec. 1031 treatment, both the relinquished (old) and replacement (new) real properties must be held for investment purposes or used in a trade or business. They can't be held for personal use. So, your personal residence won't qualify. But a vacation home might, if you rent it out some of the time and meet certain tests.

Taxpayer-friendly IRS regulations define what's real property for Sec. 1031 exchange eligibility purposes. Basically, if you swap any asset that the regulations classify as real property for any other asset that's also classified as real property, the swap can qualify for Sec. 1031 exchange treatment. 

The tax code definition of real property is broad, opening the door for many property owners to qualify for Sec. 1031 exchange treatment. For instance, you could swap an apartment building for a commercial building, vacant land, farmland or even a marina. Specifically, the regulations define real property to include:

• Ownership interests in land,
• Improvements to land, such as permanent structures,
• Unsevered natural products of land, such as crops and mineral deposits, and
• Water and air space superjacent to land, such as a marina.

Note that "superjacent" means overlying. Interconnected assets — such as systems that provide a building with electricity, heat or water — qualify as a structural component of real property if they work together to serve a permanent structure. For example, a gas line that fuels a building's heating system counts as real property.

Personal property that's classified as part and parcel of the associated real property can be included in a Sec. 1031 exchange. Personal property is considered incidental to real property if two conditions are met:

1. The personal property is a type of property that's typically transferred together with the related real property in commercial transactions, and
2. The fair market value of the personal property doesn't exceed 15% of the property's total fair market value.

Examples of such personal property may include:

• Backup power generators,
• Flooring and carpeting, and
• Window treatments.

For instance, suppose real estate partners want to swap raw land for a $20 million hotel. The hotel can include up to $3 million of personal property (15% of $20 million) and still qualify for a Sec. 1031 exchange.

IRS regs also list intangible assets that can count as real property. Examples are options, leaseholds, easements and land-development rights. They also stipulate that any property considered real property under applicable state or local law counts as real property for Sec. 1031 exchange purposes.

Tax Treatment of Boot

To avoid any current taxable gain on a Sec. 1031 swap, you can't receive any boot in the exchange. The term "boot" means cash and other property that's not classified as real property under the applicable federal income tax rules.

When mortgaged properties are involved, boot includes the excess of the relinquished property's mortgage over the replacement property's mortgage. To compute the value of the boot in this situation, subtract the debt you assume when you acquire the replacement property from the debt that you're relieved from on the property you exchange (the relinquished property).

If you receive boot, you're taxed currently on gain equal to the lesser of:

• The value of the boot, or
• The gain on the exchange transaction based on fair market values.

If you receive only a small amount of boot, your swap will be mostly tax-deferred rather than completely tax-deferred. On the other hand, if you receive significant boot, you could have a sizable taxable gain.

The easiest way to avoid receiving boot is to swap a less-valuable property for a more-valuable property. That way, you'll be paying boot rather than receiving it.  

Paying boot won't trigger a taxable gain on your side of the deal. Suppose you have cash from selling some investment assets. You could use those funds when swapping real property you currently own to buy more expensive replacement property. This transaction would qualify as a tax-deferred Sec. 1031 swap.

The untaxed gain from a Sec. 1031 swap gets rolled over into the replacement property. It's suspended there, untaxed, until you sell the replacement property in a taxable transaction.

Hypothetical Example

Suppose you've owned a small apartment building for 10 years that's currently worth $10 million. Your tax basis in the property is only $3 million. You exchange it for another building valued at $12 million. To make up the difference, you pay $2 million in cash boot, which is added to your basis in the property.

Your gain on the sale would be $7 million ($10 million minus $3 million). However, you don't have to recognize any taxable gain under the Sec. 1031 tax-deferred exchange rules, because you swapped real estate for real estate and didn't receive any boot. 

Your tax basis in the new apartment building (the replacement property) is $5 million. That's the difference between the new property's fair market value ($12 million) and the deferred gain on the Sec. 1031 swap ($7 million).  

Deferred Sec. 1031 Exchanges

Finding a seller with suitable replacement property who also wants to buy your property can be next to impossible. Fortunately, properly structured deferred exchanges can also qualify for Sec. 1031 exchange treatment.

Under the deferred exchange rules, you aren't required to make a direct, simultaneous swap of one property for another. Instead, you can use a qualified exchange intermediary that effectively functions as your agent to sell the relinquished property for cash and hold the sales proceeds. This gives you time to locate suitable replacement property. Then the intermediary can buy the replacement property on your behalf, allowing you to execute a Sec. 1031 exchange.

A typical deferred swap follows these four steps:

1. You transfer the relinquished property to the qualified exchange intermediary. The intermediary facilitates a Sec. 1031 exchange for a fee, usually based on the deal's value.
2. The intermediary arranges to sell the relinquished property for cash and holds the proceeds on your behalf.
3. You find suitable replacement property, and the intermediary buys it with the cash it's holding.
4. The intermediary transfers the replacement property to you to complete the Sec. 1031 exchange.

This series of transactions counts as a tax-deferred Sec. 1031 swap. Why? Because you wind up with the replacement property without ever taking possession of the cash involved in the underlying transactions. However, certain time limits apply. (See "Important Deadlines for Sec. 1031 Exchanges" below.)

Tax-Saving Bonus

Under the current federal income tax rules, any deferred taxable gain disappears if you die while holding the replacement property. That's because another favorable tax code provision steps up the tax basis of a deceased person's property to its date-of-death fair market value. So, under the current rules, taxable gains can be postponed indefinitely with Sec. 1031 swaps and then erased if you die while still owning the replacement property.

Your heirs can then sell the property and owe no federal income tax or just a small amount based on any post-death appreciation. Real estate fortunes have been made in this fashion without sharing with Uncle Sam.

Execute with Care

Arranging a Sec. 1031 exchange is a little complicated, but the tax savings can be well worth the trouble. Contact your tax advisor to discuss the details and to help avoid potential pitfalls when implementing this tax-saving strategy.