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New trends now emerging in popular like-kind exchanges.

The 1031 Exchange has become one of the most significant estate tax planning techniques in a dwindling list of estate tax strategies due to the various tax reform statutes that have eliminated many windfalls and loopholes which are the unintended but inevitable result of clever people poking at the soft underbelly of tax legislation.

The federal minimum wage legislation that was ultimately defeated in the United States Congress this year sought to enact various amendments to the federal estate tax provisions of the Internal Revenue Code. Although this legislation was defeated, some sort of legislation must be adopted because of the 2010 sunset provisions of the current federal estate tax law. Whatever legislation finally gets passed, it seems likely that the new estate tax legislation will not eliminate the rules regarding a "step up" in the basis of a decedent's assets at the time of death. This being said, the 1031 Exchange will only become more popular as one of the few remaining intended windfalls in the acquisition of real property for investment, trade or business.

Simply put, while a 1031 Exchange must always be a like-kind exchange, it is a mistake to think that it is a tax-free exchange; rather, it is a tax-deferred exchange. The government allows the exchangor to roll over the basis in the relinquished property into the basis of the replacement property rather than recognize gain at the time of the sale and purchase.

This will result in a lowering of the basis in the replacement property so when that property is sold, the taxpayer will have to pay taxes on the recognized gain that reflects profits realized on both the first and second properties. In that respect, the exchangor has delayed "paying the piper" until the sale of the second property.

The 1031 Exchange allowed the exchangor to forestall tax payment on the first transaction; therefore, there is more money in hand to trade up to a more expensive property. Down the road, the taxpayer is paying in future dollars at an inflated value, and, as such, those dollars are not as costly to the taxpayer as the value of dollars at the time that the original 1031 transaction occurred.

While all of the foregoing is reason enough to consider a 1031 Exchange, the "step up" in basis is a great reason! The "step up" in basis allows the estate holding a decedent's assets, including real property, to value the assets at their fair market value as of the date of the decedent's death.

Let's explore this windfall with a simple example.

Mr. Brown owns Property A. He takes the proceeds of the sale and deposits them with a Qualified Intermediary who eventually acquires Property B on behalf of Mr. Brown. (This is a typical deferred 1031 Exchange.) In our example, the purchase price of Property B is $2,000,000.00 but the basis of Property B for tax purposes is $1,000,000.00 because of the deferral of the otherwise recognized gain on the sale of Property A.

If Mr. Brown sells Property B two years later for $3,500,000.00, and during those two years he depreciates Property B by $50,000.00, then the recognized gain on the transaction would be $2,550,000.00. On the other hand, if Mr. Brown owns Property B at the time of his death, the basis of the asset would "step up" to the fair market value of Property B as of the time of Mr. Brown's death. If the fair market value of Property B would be $3,000,000.00 then the sale of Property B by the beneficiaries of Mr. Brown's estate for that same $3,500,000.00 would only recognize a gain of $500,000.00. In other words, by having the asset in Mr. Brown's estate rather than selling the asset during Mr. Brown's lifetime, the beneficiaries have avoided recognition of a gain of $2,050,000.00 (the difference between a gain of $2,550,000.00 and $500,000.00). Now that is some powerful tax planning tool!

Unfortunately, not everyone is able to hold onto their assets and pass them along to their beneficiaries. In many cases, the owner of an asset may need to liquidate that asset at some point and turn it into cash as a means of sustaining one's retirement.

With that being said, many companies (corporations, partnerships and limited liability companies) that have held real property for a number of years are confronted with the fact that real estate prices are too high not to sell and the various individuals who are investors in these companies may have differing tax strategies for the proceeds of a sale of the real property held by these companies.

This need for flexibility has given rise to the Dissolution-Type 1031 Exchange. For ease of description, let's refer to this transaction as a "DTE."

Before we can describe the benefits of the DTE, we must examine some of the rudiments of the 1031 Exchange. In order to qualify for 1031 Exchange treatment, both the assets being conveyed and acquired must be like-kind, the taxpayer must be the same person in both transactions and the assets must be held for use as an investment or for trade or business. (For purposes of simplification, we will disregard the issues of the capital asset holding period and broker-dealer status.)

The Internal Revenue Code applies a liberal standard to what constitutes like-kind property when dealing with real estate. For example, one can exchange improved property for vacant land or retail property for industrial property but one cannot exchange an interest in a company which owns real property for an interest in real property, even if the only asset owned by that company is real property.

Additionally, the taxpayer selling the relinquished property must be the identical taxpayer to the taxpayer purchasing the replacement property. Both of these requirements are solved by the DTE.

Part 2 of this article will examine the procedures and techniques involved in effecting the DTE.
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Author:Wolloch, Richard D.
Publication:Real Estate Weekly
Date:Nov 29, 2006
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