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1031 Exchanges

A Like Kind Exchange under Section 1031 of the Internal Revenue Code allows taxpayers to defer, and in some cases to completely avoid, paying capital gains tax on the sale of real estate.

The basic idea is simple. If you purchase land for $200,000 and later sell it for $500,000, you “realize” a capital gain of $300,000. In a sale, this gain is “recognized,” and taxed at capital gains rates. (For the purposes of this discussion, I am assuming you have taken no depreciation, which you can’t do with land, and you have made no capital improvements.)

If the transaction is properly structured as an exchange, and you acquire a replacement property for $500,000, the capital gain is not recognized, and no tax is paid as a result of the sale. However, your “tax basis” on the relinquished property is “rolled over” into the replacement property. Thus, if you later sell the replacement property for $500,000, the capital gain would be the same and you would pay the same tax you would have paid originally.

Exchanges can be a valuable tool for real estate investors. Even if you do eventually pay the tax, an exchange can allow the money you would otherwise pay in tax to continue to work for you until you finally cash out. Since most real estate transactions are financed, not paying $50,000 in tax now might allow you to invest as much as an additional $200,000 in the replacement property. This can be very beneficial.

Exchanges can also be a valuable part of estate planning. Under current law, heirs inherit property with a “stepped up” tax basis; they generally get the property with a tax basis equal to the value of the property at the time of death of the deceased. If they sell at that time, they realize no gain and pay no capital gains tax. Thus, by exchanging real estate rather than selling it, and holding the exchanged real estate (perhaps exchanging it again) a taxpayer can avoid paying tax until he or she dies, with the end result that no capital gains tax is paid.

This requires that the transaction be properly structured as an exchange. The regulations on how an exchange must be structured are complicated, and there are extremely strict deadlines. Not all real estate can be exchanged and who you may do an exchange with is regulated. The exchange must be structured correctly, before the sale of the relinquished property; after settlement it is too late. At Rice & Stallknecht, P.C. we have a great deal of experience with exchanges. We have over twenty five years of experience advising clients on exchanges, and structuring them correctly.

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