Income Taxes Deferred or Forever Saved With “Like-Kind” Exchanges of Real Estate Held for Productive Use in a Trade or Business or For Investment
Internal Revenue Code Section 1031 dates back to the 1920s, and shares its origins with the tax-free corporate merger and acquisition provisions. In general, Section 1031 allows for the exchange of business use or investment real estate (not personal residences or vacation homes) of the same or different kinds without income taxation, no matter how low is the depreciated tax basis of the relinquished real estate, so long as the sale proceeds are reinvested in replacement real estate in accordance with the particular rules of Section 1031, Treasury Regulations and case law. The Congressional intent behind Section 1031 has long been that if a taxpayer intends reinvestment in replacement business use or investment real estate at the time the taxpayer decides to cash in on currently owned business use or investment real estate, and if a taxpayer follows through on both these intentions within a relatively short time of each other, it is economically inappropriate to impose income taxation, since business or investment utilization is ongoing.
To preserve the potential for future income taxation, Congress has all along mandated that the lower depreciated tax basis of the relinquished real estate carries over and onto the replacement business use or investment real estate, rather than the replacement real estate having a typically much higher cost tax basis equal to its purchase price. Under current tax law, if the replacement real estate is owned directly by an individual or indirectly by an individual through a limited liability company or partnership, the fair market value of the replacement property as of the date of death becomes the new tax basis of the replacement real estate, in effect, converting income tax deferral into a permanent income tax savings to the estate and heirs of the decedent. An example reflecting some of the more familiar, particular rules illustrates the income tax savings power of Section 1031 taking into account a date of death value for replacement property.
An individual owns all of the member interests of a limited liability company, which in turn owns a mortgage-free office building worth fifty million dollars. The original cost, that had been thirty million, plus later added capital improvements costing ten million, have been the subject of years of MACRS straight line tax depreciation deductions such that the adjusted, depreciated tax basis is now eight million. One day an unrelated party makes an offer of fifty million dollars. The taxable gain on a sale would be forty-two million, and Federal and state income taxes roughly thirteen million plus in the metropolitan area. The (indirect) owner not only decides to sell, but also decides to diversify his holdings. The income tax deferral and savings of this strategy were no small part of the decision.
Consequently, the sales contract requires the buyer of the building to cooperate reasonably with the selling LLC’s effectuating a Section 1031 “deferred” like-kind exchange. Before closing, the LLC enters into an Exchange Agreement naming a bank’s trust department as a “qualified exchange intermediary”. The building is sold with the buyer wiring the purchase money to the qualified exchange intermediary acting for the benefit of the seller. Within forty-five days of sale closing, the LLC delivers to the exchange intermediary a list of three replacement warehouse properties located in different states. Within one hundred eighty days of closing, the LLC purchases all three of the properties for fifty-one million in total. The qualified exchange intermediary wires fifty million to the sellers and the LLC delivers a certified check for one million to one of the sellers to make up the shortfall to that seller. The eight million in adjusted tax basis of the relinquished property is spread over the three replacement properties in accordance with their relative purchase prices. Hence, remaining tax depreciation of the replacement properties is relatively low compared to their cost, but no income taxes are due on the sale.
Assuming that the owner dies four years later when the value of the replacement properties totals fifty-five million, the excess of fifty-five million over four million of the remaining depreciable basis is a new basis for tax depreciation spread over them in accordance with their then relative values. New depreciation lives begin with a fifty-one million starting basis, while four million of tax basis is depreciated as per prior practice. The deferral of income taxes has been replaced by a permanent income tax savings adjustment. Although the tax savings effects of a new date of death value tax basis has been part of Federal tax law for approximately ninety years, a good number of Federally elected officials now and in the future are determined to repeal the relevant Internal Revenue Code section.
Working as part of a team, the experienced attorneys at Herold Law, P.A., can be of service to you on both the commercial real estate and tax qualification sides of a Section 1031 like-kind exchange of real estate. Please don’t hesitate to contact Robert S. Schwartz, Esq., at 908-679-5011 or contact him at [email protected] for further information or assistance. .