Section 1031 of the Internal Revenue Code offers significant advantages for taxpayers engaging in commercial real estate transactions. It permits an owner to defer capital gain on the exchange of property that has been held for productive use in a trade or business or for investment by providing an exception to the general tax rule requiring the current recognition of gain (or loss) upon the sale of property.
Why does the IRS allow a deferral of taxes? It’s a matter of public policy – to encourage taxpayers to reinvest in capital assets by providing an incentive for the disposition of obsolete or marginal business or investment assets for similar, “like-kind,” assets. The IRS treats the disposition and subsequent acquisition of like-kind assets as, effectively, a continuation of the taxpayer’s original investment. As long as the technical rules found in the code and the related 1031 regulations are strictly followed, the transactions will be viewed as an exchange of assets – rather than as two unrelated sales.
The gain from the disposition of business or investment use property – the disposition of the relinquished property – will not be recognized for federal income tax purposes. That includes the tax on depreciation recapture as well as tax on the appreciation component. Recognition of the gain/recapture is deferred until the subsequent disposition of the property that is acquired by the taxpayer in the exchange – commonly referred to as the replacement property – in an otherwise taxable transaction.
It is best to show the economics of a 1031 exchange by using a simple example, ignoring brokerage commissions, fees, other transaction costs and state taxes. Let’s say that Tom Taxpayer purchased rental property years ago for $500,000 and, since then, has taken $300,000 worth of depreciation so his current adjusted basis is $200,000. He is selling the property for $1 million. Thus, Tom’s anticipated gain is $800,000 (the sale price minus the adjusted basis). He has no mortgage to pay off, so his cash proceeds from the closing are $1 million. Tom plans on putting away $150,000 for federal taxes that he’ll owe on account of the sale (reflecting a 15 percent capital gains rate for the appreciation component and Tom’s 25 percent tax rate for the recapture portion). He will use the balance of the proceeds to buy a small shopping center as his replacement property.
If the shopping center costs $1.1 million, Tom will need a loan for $250,000. The economics change if Tom does his deal as a 1031 exchange. The first part stays the same; he still gains $800,000. But now Tom wires all of the equity – the $1 million in proceeds – to his qualified intermediary, a position that was established to prevent a taxpayer from receiving funds so he is not deemed to have engaged in a taxable sale. The closing agent wires the $1 million directly to Tom’s QI, who wires it into the second closing. This allows Tom to use all of the equity from his first closing to acquire the replacement property and he now needs a loan of only $100,000. Tom was able to take the taxes that he would have set aside and use that equity toward acquiring the shopping center.
Here’s another scenario. Assume that Tom wants to buy a much larger replacement property and his lender requires a minimum loan-to-equity ratio of ratio of 3:1. Without the exchange, Tom’s proceeds after taxes are $850,000. That buys him a property of $3.4 million with the leverage. With a 1031 exchange, the additional equity of $150,000 gets him into a property worth $4 million. By doing an exchange, Tom is able to leverage into a larger property.
But that doesn’t mean that a taxpayer never pays taxes when doing an exchange. In order for a 1031 exchange to be successful and not have any taxable component, the taxpayer must not receive “boot,” which refers to proceeds at the closing table or from the QI after an exchange terminates. There are different types of boot, including cash boot or mortgage boot, but the rule comes down to this: If you complete an exchange with cash or net debt relief, you will realize some form of taxable boot. The rule of thumb is that you should trade up (or at least remain equal) in property value and equity to avoid taxable boot. Because Tom used his equity to acquire his replacement property, and traded up in value, he will not incur boot in his exchange. Tom’s gain is completely deferred. But if Tom were to dispose of his relinquished property for $1 million and acquire a replacement property worth only $900,000, he would incur $100,000 in taxable boot.
Rules of Thumb
The result does not change if Tom had a mortgage. Assume that he had a mortgage of $400,000 on his relinquished property. He pays off the loan at closing with the proceeds, and sends $600,000 to the QI, who sends the equity in to buy a $900,000 replacement property. Tom even adds $300,000 in cash at the second closing. Is there still boot? Yes. Tom went up in equity but down in value. He received $1 million in benefits from his sale – $400,000 of proceeds used to pay off his loan plus the $600,000 balance in cash – but only reinvested $900,000 into his new property.
As noted earlier, the gain from a 1031 exchange is only deferred. The taxpayer will pay taxes on his or her gain later, when the replacement property is sold. The “memory” of the deferred gain is accomplished by adjusting the cost basis of the replacement property, which is its value when the taxpayer acquired it minus the amount of gain deferred in the exchange.
Assume that the replacement property is sold two years after Tom acquires it and there is no depreciation or change in value. Ordinarily, selling a building for the same amount it was acquired would result in no gain. But in a 1031 exchange, the special calculation of basis for the replacement property locks in the deferred amount of the earlier gain, and that gain is subject to taxation when the replacement property is sold. So when Tom sells the replacement property for $1.1 million with an adjusted basis of $300,000, he will recognize the deferred gain of $800,000.
The rules governing 1031 permit the taxpayer to take cash or other property off the closing table, but it’s deemed to be taxable boot. And that will be true even if the taxpayer trades up in value and equity. The liability netting rules do not allow for cash boot received by the taxpayer to be offset by cash given for the replacement property or by debt incurred. So if you take $100 off the closing table when you sell the property, that’s taxable boot even if you later supplement the equity that the QI sends to the replacement closing.
The liability netting rules are more permissive when it comes to debt. Debt relief on a disposition can be offset with new debt incurred, additional cash or a combination of both. A loan can be offset it by taking a lesser loan on the replacement property and making up the difference with cash.
How can you determine if a 1031 exchange makes economic sense? Remember that you are taxed on the lesser of your taxable boot or your potential taxable gain. If you end up with boot, either as the result of taking away cash from the 1031 exchange, or failing to trade up in value and in equity, then you have to compare the amount of the potential gain with the amount of taxable boot that results from your exchange. The less boot you anticipate, the greater the deferral and the economic benefit in doing the exchange. If boot can be kept to zero, the exchange will completely defer the tax.
But other elements come into play. If you’re trading up in the value of replacement property, the future depreciation benefits of that property will be affected. Its cost basis will be lowered by the component of deferred gain, which lessens the stream of depreciation that would have been available if the property had been purchased outside of an exchange. Consult with an accountant, tax attorney or other professional tax advisor to review your proposed transaction and help plan the maximum economic benefits.
