Defer capital gains tax with 1031 exchange

If the transaction is structured correctly under section 1031 of the Internal Revenue Code, the investment property can be sold, and the proceeds reinvested in another investment property without the owners realizing any capital gain.

Instead of losing about 21 percent of the investment to taxes (assuming a federal tax rate of 15 percent and a Missouri state tax of 6 percent), property owners could use a 1031 exchange to keep the entire proceeds from a sale working for them.

For example, suppose a couple – the Smiths – are getting ready to retire. They own 200 acres of farmland that they have held for many years. The property cost just $500 an acre, but because the city has expanded out near their land, the property recently appraised at $7,000 per acre. The Smith’s tax basis is $100,000 (the original purchase price), but the property would now sell for $1.4 million. If sold at the appraised value, the Smith’s would have a capital gain of $1.3 million, and owe a capital gains tax of about $275,000.

Instead of selling the property and paying the tax, the Smiths could consider doing a tax-free exchange. They would enter into a written agreement with a qualified intermediary who would assist with the exchange, and also into a contract with the buyers of their property, without accepting any down payment or proceeds directly from the sale. The sales contract discloses to the buyer that the seller is selling the property in a tax-free exchange. This disclosure also may be made at closing. All proceeds from the sale are dispersed to the qualified intermediary, who holds the funds until the Smiths close on the replacement property, completing the exchange.

Technicalities

There are technical rules to follow in making a tax-free exchange. For example, within 45 days of the closing, the Smiths must identify three properties (or any number of properties up to an aggregate value not to exceed 200 percent of the sale price of the property sold) that they intend to use as replacement properties. If they fail to designate replacement property within 45 days, they forfeit the right to make a tax-free exchange. They must actually close on the replacement property not more than 180 days after sale of the exchange property.

Purchase options

The Smiths are not confined to the purchase of farmland. They may buy a warehouse, multifamily housing, single-family housing or an office building as replacement property. Any type of investment property may be used as replacement property. It is also possible to do a partial tax-free exchange, paying capital gains tax on the rest. But in order to defer all taxation, the Smiths must purchase property for a value equal to or greater than the sales price of the property sold, and have debt equal to or greater than that which was on the property sold.

It is also possible to do a reverse exchange, buying the replacement property before selling the property that is already owned. The rules are highly technical, but a qualified intermediary can assist with the numerous requirements that apply.

The tax-free exchange may be an excellent way to keep more of your investment.

Stephen F. Aton is an attorney practicing corporate law and estate planning and real estate. He is the owner of Aton Title and can be reached at steve@atonlaw.com.