The 2015 tax season brings an end to the 1031 or like-kind exchange of property. It means the end of dramatic tax benefits of a like-kind exchange of property. Taxpayers using this technique in 2007 (the last year for which figures were available) deferred the tax on a total of $82.6 billion in gain, due mainly to swaps involving real estate and vehicles.
Let’s start with this basic premise: If a client owns investment property like real estate that has appreciated substantially in value, they might owe a large capital gain when they finally sell the property. In addition to paying the maximum 20% tax rate on long-term gains if they’re in the top ordinary income tax bracket (15% for most others), they may also be liable for the 3.8% surtax on net investment income. Yet there is no current tax liability if they exchange the property for “like-kind” property in time. The tax is deferred until they sell the replacement property, if ever.
Surprisingly, the IRS was quite lenient when it came to treating investment property as being like-kind under this tax law provision. For example, you could have swapped an apartment building for a warehouse, or vice versa, and still qualify. But both the property being relinquished and the property you were acquiring had to be investment or business property. In other words, a personal residence couldn’t be part of a like-kind exchange on either end.
Typically, real estate swaps were difficult to consummate without involving multiple parties. Both the IRS and the courts had approved such arrangements where the timing requirements were met. In fact, a real estate investor could use a qualified intermediary to “park” the property until a qualified like-exchange could be finalized.
Consider the tax impact for a top-bracket investor who bought an apartment building for $500,000 years ago that is now worth $1.5 million. If the investor sells the property for $1.5 million, the $1 million gain will effectively be taxed at a 23.8% rate (20% + 3.8%), resulting in a tax bill of $238,000, not even counting any state taxes. However, if a timely swap of like-kind properties was arranged, the federal income tax bill is zero!
Previously, we alluded to meeting certain timing requirements. To qualify for tax deferral on a like-kind exchange, you must:
- Identify or actually receive the replacement property within 45 days of transferring legal ownership of the relinquished property
- Receive title to the replacement property within the earlier of 180 days or your tax return due date (plus any extensions)
Note that the 180-day period begins to run on the date legal ownership of the relinquished property is transferred. When the period straddles two tax years, the deadline might be shortened by the upcoming tax return due date. For instance, if a client identifies replacement property on December 1, 2014, the exchange must be completed by April 15, 2015, absent any tax return extension. To learn more, contact a member of the Gratia Group team at (239) 333-2221.