What are we talking about? Tax deferred exchange (a.k.a. I.R.C. §1031 exchange, “like-kind” exchange, or “Starker” exchange). A tax deferred exchange is nothing more than a type of transaction that permits the taxpayer to legally defer the payment of taxes on capital gains upon the sale of investment property. You will note that I said “defer”, not avoid. Nevertheless, with the proper estate planning, the tax deferral mechanism could turn into a tax avoidance mechanism (this will be explained later).

So what is the goal? The goal is to take advantage of this opportunity to

get the time valued use of Uncle Sam’s money and use that money to help buy your investments. When you sell a piece of investment property, assuming the property has increased in value, the proceeds will be comprised of three parts:

(i) Basis: Your initial investment in the property, (less depreciation)

(ii) Capital Gains: Your profit from the increase in value of the property; and

(iii) Taxes: Uncle Sam’s portion of your capital gains which is currently taxed at a maximum rate of fifteen (15%) percent.

The tax deferred exchange lets you take Uncle Sam’s portion and reinvest it without paying him, yet.

So how does it work? The rules are very strict and must be followed precisely; otherwise, the transaction will be overturned causing taxes to be paid with penalties. At a minimum, there are two properties involved: the “Relinquished Property” and the “Replacement Property”. The Relinquished Property is the investment property that you currently own and that you are selling. At some point between the time you contract to sell the Relinquished Property and the time you close on that sale, you must enter into a written agreement with a Qualified Intermediary who will hold your sales proceeds until you reinvest them in another piece of investment property, the Replacement Property. All time requirements run from the date upon which you close on the sale of the Relinquished Property and must be strictly adhered to. Within forty-five (45) days after closing, you must identify potential replacement properties. (If you identify more than three properties, stricter rules apply.) Within one hundred eighty (180) days after closing on the Relinquished Property, you must close on the Replacement Property. As a part of this process, the Qualified Intermediary will provide the proceeds held on your behalf to purchase the Replacement Property.

Again the requirements are very stringent and will require the professional drafting of documents and guidance through the process.

What kind of property can be used for the exchange? The rule is “like-kind” property. Within the realm of real property, what is considered “like-kind” is liberally construed provided the properties involved are investment properties or properties held for productive use in a trade or business. Typically, the property involved on Hilton Head Island is investment property. The tax deferred exchange begins with a piece (or several pieces) of investment property. A personal residence will not qualify. On the other hand, raw land and rental property clearly do apply. Second homes that are not rented will most likely not qualify. At a minimum, that will be an aggressive stance to take with the IRS.

So what do you mean about “investing using Uncle Sam’s money”? Let’s say that ten years ago, you originally purchased an oceanfront villa (we will call it “Villa A”) for $200,000. You now have a contract to sell Villa A for $700,000. (Villa A is your “Relinquished Property” using tax deferral language.) With your basis in the property being $200,000 and your sales price being $700,000, upon the sale you would have capital gains in the amount of $500,000. At the current maximum capital gains rate of 15%, you would normally owe Uncle Sam $75,000 in capital gains taxes. However, because you are doing a tax deferred exchange, Uncle Sam is going to permit you to take his $75,000 and use it to purchase your next piece of investment property (your “Replacement Property”) and pay him for those taxes at some later date; provided, of course, that you meet all the requirements for executing the tax deferred exchange. (Note: The result is even more dramatic if you have depreciated the property where your basis is less than the original $200,000 you invested in the property.)

How can I turn this “tax deferral” mechanism into a “tax avoidance” mechanism? Interestingly enough, should you either hold onto the Replacement Property or continue to “roll” the capital gains into new investment properties using the tax deferred exchange mechanism, upon your death the property will go into your estate and your heirs will get a stepped-up basis in whatever investment property you own at that time. What this means is that there is no longer any capital gains on the property because the basis gets “stepped-up” to the then current value of the property. Using our previous example, the original basis was $200,000. If at the time of your death the current value is $700,000, your heirs or devisees will get a stepped-up basis meaning their new basis in the property is $700,000. When they decide to sell the property, capital gains taxes will be calculated based upon the stepped-up $700,000 basis, not the original $200,000 basis. As a result, Uncle Sam just lost $75,000 of his capital gains taxes. As a result, you will have turned a tax deferral mechanism into a tax avoidance mechanism. (Obviously, there will still be estate tax issues with which to contend.)

Are there other scenarios for completing a tax deferred exchange? Yes. For instance, you can do a reverse exchange where you buy the Replacement Property before you sell the Relinquished Property. Or, you could have multiple properties on either the Relinquished Property side of the deal or the Replacement Property side of the deal or both. Or, you could have a three party deal. Any of these scenarios will work; however, the rules get tricky and are beyond the scope of this discussion. Nevertheless, should you want to discuss anything about tax deferred exchanges, please feel free to contact us as we handle these types of deals regularly.