Consider a Section 1031 Exchange
Permanent tax reduction is possible. Internal Revenue Code section 1031, tax deferred exchanges, provides investors with one of the last available tax shelters by allowing them to avoid paying any taxes when investment properties are sold. Why, when and how this happens are questions CPAs should be able to answer. Section 1031 can provide permanent deferral of the gain on investment real estate properties. Investors never have to pay taxes on equity buildup as long as they keep exchanging (instead of selling) properties until their death--when the basis of the properties will automatically be adjusted to the market value on the date of death, eliminating all gain. HOW AN EXCHANGE WORKS Two property owners rarely want each other's properties. In reality, most exchanges involve three parties: the taxpayer who wants to sell (but defer paying taxes), the buyer for that property and a seller for another property the taxpayer wants to transfer his or her equity into. As usual, the sales contracts are signed by the taxpayer (since he or she has to be approved for any financing) but at closing a facilitator is hired to do the selling and buying in the taxpayer's place. If the taxpayer instead sells the property on his or her own, the Internal Revenue Service would not allow exchange treatment because the taxpayer would get cash to make the new purchase and receipt of cash is taxable. However, when a taxpayer exchanges into another "like-kind" property--using the built-up equity instead of cash--the IRS view is that he or she really is continuing the original investment. Like-kind is defined as real property, for real property. This means not only exchanging an apartment building for an apartment building but also exchanging an apartment building for a farm, vacant land, a cranberry bog or any other real property, as long as the new apartment building is not the investor's personal residence and he or she intends to hold the acquired property "for productive use in trade or business" for at least six months and preferably a year. To sell it sooner would classify the taxpayer as a dealer, which is not allowed. Example. Ada Smith has owned a 30-unit apartment building for 12 years. She originally paid $500,000; today it is worth $800,000. As a result of accelerated depreciation, Smith's adjusted tax basis is now $120,000. If she sells the property, her gain will be $680,000. In her 28% federal tax bracket, she will have to pay $190,000 in taxes. Smith asks her CPA how she can transfer her $450,000 equity ($800,000 building value minus $350,000 debt) to another property without paying any tax. An "assignment of contract" clause is added to the sales contract when a buyer is found for Smith's budding and to the purchase agreement for the new property she wants to exchange into. This clause authorizes the facilitator to sell Smith's property and transfer the profit to the purchase of another one. At the closing, the facilitator briefly takes title to Smith's property before transferring it to the buyer because it would be illegal for the facilitator to sell (or exchange) real property without having proper tide. FINDING A FACILITATOR Most facilitators today are associated with tide insurance companies because there is more security for the funds involved since the title company is bonded. Very few CPAs act as facilitators because there must be a two-year period between the time a CPA was the client's accountant and when the CPA acted as facilitator. Similarly, a taxpayer's attorney, employee or real estate broker also is considered to be "related" to the taxpayer and thus cannot act as facilitator for an exchange transaction. ASSESSING AN EXCHANGE To make certain such transactions will defer taxes and are financially worthwhile, CPAs can use the calculation sheet in exhibit 1, page 46, to simplify the procedure. Example. …