Using a 1031 Exchange to Shelter Gains

By: Jan Paul C Ferrer

This article suggests how readers may shelter a gain on an investment property under IRS Section 1031. It describes how the transaction works, what restrictions apply and how it might be used–or not–in different situations.

In business dealings, cash may be king. But when it comes time to sell assets, cash can also trigger tax. “Whenever you sell business or investment property and you have a gain, you generally have to pay tax on the gain at the time of sale,” writes the Internal Revenue Service on its Web site.1 But disposition of a business or investment asset need not be a cash transaction. You may find an attractive alternative in an exchange of like assets, what the IRS calls a 1031 exchange. In fact, you may find that a 1031 exchange offers you the potential for effective tax management in a variety of business and investment circumstances. In the broadest sense, a 1031 exchange is not considered a sale but a trade, one in which a business or investment asset is traded for another asset of, in the IRS’s words, “like kind.” Assuming that all the rules and conditions are met, a trading of assets under Section 1031 allows you to treat the new asset as if you’d owned it from the day you bought the old asset–no gain, no loss, and no taxable event taking place in the exchange. Of course, there will be a tax reckoning eventually, but only when you ultimately sell the asset.

Cash versus 1031 Exchange The following illustrates the differences between a cash transaction and using a 1031 exchange. In this hypothetical example, an individual is selling his $500,000 rental property, which he purchased five years ago for $300,000, and buying a new $500,000 rental property. The example assumes that both properties qualify as like kind for tax reporting purposes.

Cash Transaction 1031 Exchange Sale of old property results in taxable gain of $200,000. Seller will be responsible for paying long-term capital gains tax on this gain, or $30,000, assuming a capital gains rate of 15%. Transaction is treated as an exchange and triggers no long-term capital gains tax. New property carries a $500,000 tax basis. Capital gains tax will be due upon future sale for any appreciation above this amount. New property carries a $300,000 tax basis. Capital gains tax will be due upon future sale for any appreciation above this amount.

Eligible Assets A primary test of whether an asset qualifies for a 1031 exchange is that it must be held for use in a trade or business, or for investment. For example, a house you rent to others might qualify, but real estate used as your primary home or vacation home would not. Livestock, farm and lumber land, motor vehicles, boats, fine art, precious metals and gemstones held for investment purposes could also qualify. However, business inventory and stock-in-trade are excluded. So are stocks, bonds and other securities, as well as partnership interests and certificates of trust. Keep in mind that tax rules define what asset is like kind to another. For example, the real estate category is simple–virtually all real estate is deemed to be like kind, regardless of the condition or development of the individual properties in the exchange (the principal exception: property outside the United States is not considered like kind to property in the Unites States). In contrast, the rules for livestock exchanges are more complex: Only certain species may be used for a 1031 exchange, and all animals in any such exchange must be of the same gender. Similarly, trucks in general are not considered to be like kind to passenger cars, but SUVs, crossovers, minivans and certain pickups may be.

Guidelines for a Transaction It may sound obvious when said, but a simultaneous purchase and sale for cash would not be a 1031 exchange, at least as far as the tax code is concerned. To qualify, the deal must be structured as a quid-pro-quo barter deal under a single contract. If the values exchanged are not exactly equal, cash can be used to make up the difference, but the party receiving the cash would have to recognize the cash portion for tax purposes. The transaction must also be conducted by a third-party qualified intermediary, who oversees the sale of the relinquished property and purchase of the replacement property. The exchange itself does not have to be simultaneous, but the windows for carrying the deal out are quite rigidly defined. As a rule, the only kind of hardship that can stretch a 1031 exchange deadline is a presidentially declared state of emergency. Otherwise, transgression of 1031 deadlines makes the entire transaction immediately taxable.

Footnotes/Disclaimers: 1Source: The Internal Revenue Service, Like-Kind Exchanges Under IRC Code Section 1031; http://www.irs.gov/uac/Like-Kind- Exchanges-Under-IRC-Code- Section-1031 (also used for general background information in this article). Information in this article was also taken from 26 USC § 1031 – Exchange of property held for productive use or investment, Legal Information Institute of the Cornell University Law School, http://www.law.cornell.edu/uscode/t ext/26/1031. If you’d like to learn more, please contact Jan Paul Ferrer. Article by Wealth Management Systems, Inc. and provided courtesy of Morgan Stanley Financial Advisor. The author(s) are not employees of Morgan Stanley Smith Barney LLC (“Morgan Stanley”). The opinions expressed by the authors are solely their own and do not necessarily reflect those of Morgan Stanley. The information and data in the article or publication has been obtained from sources outside of Morgan Stanley and Morgan Stanley makes no representations or guarantees as to the accuracy or completeness of information or data from sources outside of Morgan Stanley. Neither the information provided nor any opinion expressed constitutes a solicitation by Morgan Stanley with respect to the purchase or sale of any security, investment, strategy or product that may be mentioned. Morgan Stanley Smith Barney LLC (“Morgan Stanley”), its affiliates and Morgan Stanley Financial Advisors do not provide tax advice. Individuals are urged to consult their tax advisor regarding their own tax or financial situation before implementing any strategies. Morgan Stanley Financial Advisor(s) engaged Via Times to feature this article. Jan Paul Ferrer may only transact business in states where he is registered or excluded or exempted from registration [http://www.morganstanleyfa.com/f errer. Transacting business, followup and individualized responses involving either effecting or attempting to effect transactions in securities, or the rendering of personalized investment advice for compensation, will not be made to persons in states where Jan Paul Ferrer is not registered or excluded or exempt from registration.