What could be a more compelling tax planning technique than one that allows a lifetime’s worth of appreciation in the value of property to permanently escape income tax? The answer is found in a combination of the like-kind exchange rule of Section 1031 and the stepped-up basis rule found in Section 1014 of the Internal Revenue Code. The technique is best illustrated by example.
At age 30, Michael purchases his first investment property, a small apartment building, for $150,000. At age 36, Michael sells the building for $275,000 and uses the proceeds as a down payment on a strip shopping center costing $500,000. At age 50, the shopping center is sold for $1.3 million and the net proceeds are used to buy an office building for $2.2 million. At age 68, Michael sells the office building for $4 million and buys two “big box” retail stores under long-term triple-net leases to credit quality national tenants. Michael dies at age 78 when the buildings are worth $4.4 million. His children inherit the real estate.
Properly structured under the like-kind exchange rules, each sale and purchase can be accomplished without paying any income tax. And by virtue of the stepped-up basis rule, Michael’s children could sell the real estate at $4.4 million, and neither the children nor Michael will have ever paid income tax on the $4.25 million of appreciation that accrued over Michael’s 48 years as a real estate investor.
Requirements. To qualify a sale and purchase as an exchange, the new property (NP) must be identified within 45 days of the date the old property (OP) was transferred. In general, closing on the NP must occur within 180 days of the transfer date of the OP. Most importantly, between the sale date and the buy date, the taxpayer must not have control over the proceeds of sale.
The IRS has established certain “safe harbors” that allow the use of so-called “qualified intermediaries” to act as special agents. For a fee, the intermediary will facilitate the sale of the OP, hold the net proceeds of sale and facilitate the purchase of the NP, all in keeping with the exchange rules, and in the process avoid the complication of having to have the buyer of the OP or the seller of the NP cooperate in the exchange. Taxpayers are well advised to use qualified intermediaries and thus safe harbor their exchanges.
Finally, the taxpayer must trade up or even, meaning that the NP must be purchased for a price equal to or greater than the selling price of the OP, and in the process use all of the net proceeds of sale. Trading down in price (or not utilizing all proceeds of sale) creates “boot,” which will result in at least partial gain recognition.
As can be seen from the above example, in the context of real estate, “like-kind” has a broad meaning. One can trade an apartment building for a retail shopping center or an office building. Raw land held for investment can be exchanged for improved property. A taxpayer who has owned a manufacturing facility, which he leased, to his company can sell the real estate and use the proceeds to buy a new manufacturing facility, or buy investment real estate. Real estate which is not held for investment or for use in a business (such as real estate held by a builder as inventory or which was purchased with the intent to “flip” or resell) will not qualify. Owner occupied residential property does not qualify for an exchange. Foreign real estate cannot be exchanged for U.S. real estate.
Using Equity Build-Up. While Michael would certainly like to avoid gain, it would appear that he couldn’t take his equity out the property without paying tax. Not true. By refinancing his property, Michael can take money out of the property tax-free, and not interfere with his ability to exchange. The refinancing must occur before he sells a property or after he buys a property, but not in the course of the trade--in other words, Michael cannot leverage up to take cash off the table between the two legs of the exchange.
Tough Cases The compliment to the admonition “swap ‘til you drop” is to “make it fit.” The exchange rules are detailed, and not all sales and purchases will fit the rule. For example, one cannot do a reverse exchange--which is a purchase of the NP before the OP is sold. However, there are accommodation parties that can put reverse exchanges forward by buying and holding the NP until the OP is sold, or buying the OP from the taxpayer before the NP is purchased. Real estate to be constructed can also qualify as the NP in an exchange. Interests in real estate partnerships cannot be exchanged, but with advance planning it is possible to have certain real estate held in co-tenancy, which will allow each co-tenant to exchange (or not exchange) as he or she pleases, separate from the other owners. Sales in exchange for installment notes present other problems, but accommodation parties can again be used to “liquefy” installment notes in order to complete an exchange.
Other Uses. Although most exchanges involve real estate, many other types of property qualify for exchange treatment. For example, businesses that own delivery vehicles can trade for new delivery vehicles and avoid tax on the gain, even depreciation recapture. The rule applies similarly for certain types of machinery and equipment used by businesses and leasing companies. While in a broad sense, one business cannot be exchanged for another business; many of the underlying assets (other than goodwill) can be exchanged for similar assets.
Conclusion. As our example illustrates, effective estate planning can be aided by good income tax planning in a way that turns income tax deferral techniques into permanent tax savings. Merely by timing a taxpayer’s purchase and sale of investment property so that they occur within 180 days, and by properly timing refinancings to take out the desired amount equity, a client such as Michael can pretty much have his cake and eat it too, maximizing his own use of cash and the after-tax bequests he makes to his heirs.