Like-kind exchanges: deferral is not always the best option.

• Author: Nash, Claire Y.

EXECUTIVE SUMMARY

* Many taxpayers assume that the gain deferral provided by a like-kind exchange always makes a like-kind exchange of an eligible property more advantageous from a tax stand-point-than a sale of the property. However, depending on a taxpayer's situation, a like-kind exchange may not be better from a tax standpoint than a sale of the property followed by a purchase of new property.

* In comparing a like-kind exchange of properties with a sale or purchase of property, the taxpayer must take into account the difference in depreciation deductions after the two transaction forms, the value of the deferral of the recognition of gain in a like-kind exchange, and the administrative costs of the like-kind exchange.

* The absolute amount of tax savings provided by the deferral of gain in a like-kind exchange and the present value of those savings can be dramatically affected by changes in the taxpayer's marginal tax rates, the overall rates of tax on ordinary income and capital gains, and the taxpayer's rate of return on investments.

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When taxpayers sell real estate and replace it with like-kind property, Sec. 1031 gives them the opportunity to defer taxation on the gains they may have on their transactions. Anytime there is an opportunity to defer tax costs, tax practitioners and their clients automatically tend to assume that they should take advantage of the opportunity. However, in the case of like-kind exchanges, it is not always in the taxpayer's best interest to elect to defer the recognition of gain on realty.

In order to qualify for a like-kind exchange on realty, taxpayers usually must engage the services of an intermediary at the cost of an agency fee, and they are under a relatively stringent time constraint for finding a replacement property. Moreover, deferral of tax on the gain results in a limited basis in the qualified replacement property, which, in turn, limits the amount of depreciation deductions available to the taxpayer on the qualified replacement property over its cost recovery period.

When the tax rates on a taxpayer's gain from the sale of realty are substantially lower than the marginal tax rate on the ordinary income that he or she could shelter with depreciation deductions on newly acquired property, the taxpayer may be better off forgoing deferral of tax on the gain. In such instances, the taxpayer would have a higher depreciable basis in the acquired property and thereby have a larger net tax savings over time from the higher depreciation deductions.

This article examines whether deferral of the recognition of gain under the like-kind exchange provisions of Sec. 1031 is more advantageous for a taxpayer than recognition of the gain considering the lower capital gains tax rate, the tax on unrecaptured Sec. 1250 gain, and the taxpayer's marginal tax rate. (1) It also examines other factors that taxpayers should consider when determining whether to undertake a like-kind exchange. Illustrations compare the tax consequences of deferring the tax on the gain from a sale of real estate through a like-kind exchange with the tax consequences of recognizing gain on the sale of real estate, paying taxes on that gain, and deducting a larger amount of depreciation on property acquired with the sales proceeds.

Sec. 1031 Overview

Only "property held for productive use in a trade or business or for investment" (2) is eligible for deferral of gain or loss under Sec. 1031, and deferral is available only to the extent that eligible property is "exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment." (3) Taking advantage of the deferral provisions of Sec. 1031 can prove especially troublesome for taxpayers who hold real estate for investment or productive use in a trade or business and also hold other real estate properties as inventory. For example, a real estate investor/ dealer who buys properties with the intent of repairing and reselling them, but also buys properties to rent, must be able to clearly distinguish between his or her inventory and his or her rental properties.

Exchanges of any "stock in trade or other property held primarily for sale" (4) (emphasis added) are ineligible for gain deferral under Sec. 1031. This provision renders real estate bought merely to "flip" through a resale ineligible for like-kind exchange treatment. The tax on the gain from the sale of rental real estate, however, should be eligible for deferral through a like-kind exchange of the property.

Simply holding a property out for rental before ultimately selling it is unlikely to constitute persuasive evidence that the property was rental property rather than property held primarily for sale. If the primary purpose for initially acquiring property was to resell it, then it would seem unlikely that renting the property out while it is being marketed would convince the IRS that gain from the sale of the property would qualify for gain deferral under Sec. 1031 since the determination must be based on the primary purpose for which the property was held. (5)

Sec 1031 specifically excludes a number of other categories of property from eligibility for deferral of recognition of gain. Those categories include stocks, bonds, and notes; (6) other securities or evidence of indebtedness or interest; (7) interests in a partnership; (8) certificates of trust or beneficial interests; (9) and choses in action. (10) In addition to the broad limitations on what types of property qualify for deferral of recognition of gain under Sec. 1031, there are also some specific statutory provisions concerning what constitutes like-kind property.

For example, livestock of different sexes are not considered like-kind property even if they are of the same breed. (11) Certain exchanges between related parties that would have qualified as like-kind exchanges had the parties not been related are not considered to be like-kind exchanges for purposes of Sec. 1031. (12) Exchanges of U.S. realty or personal property used primarily in the United States for realty located outside the United States or personal property used primarily outside the United States are not considered to be like-kind exchanges under Sec. 1031, regardless of how similar the exchanged properties are. (13)

Although the exclusions and restrictions contained in Sec. 1031 undoubtedly reduce the number of like-kind exchanges that would otherwise take place annually, the section does include provisions that help facilitate the execution of a like-kind exchange. It is usually difficult, if not impossible, for the owner of eligible real property who would like to enter into a like-kind exchange to find another owner of attractive eligible real property who is interested in exchanging real estate. Sec. 1031 includes provisions that permit the use of an intermediary to enable taxpayers to overcome this lack of "double coincidence of wants."

Using an Intermediary to Effect a Like-Kind Exchange

Taxpayers who wish to engage in a Sec. 1031 like-kind exchange have the option of entering into an agreement to sell their property and assigning the sales contract to a "qualified intermediary." In accordance with the provisions of Sec. 1031 and the regulations thereunder, the intermediary will complete the sale and hold the proceeds in escrow until the seller identifies a qualified replacement property. Once the taxpayer identifies the replacement property, the intermediary pays for it using the funds from the sale of the original property. In order for a replacement property to be considered received in exchange for the property that the intermediary sold on behalf of the owner, the taxpayer must identify the property "on or before the day which is 45 days after the date on which the taxpayer transfers the property...