On December 31, 2012, the reduced 15% tax rate on long term capital gains is scheduled to expire. If the reduction is not extended and taxes on long term capital gains increase, we may see an increase in like-kind, tax deferred exchanges (often referred to as “1031 Exchanges” as they are permitted pursuant to Section 1031 of the Internal Revenue Code). A 1031 Exchange permits a tax payer to “exchange” real (and other investment) property for investment property of the same kind, deferring the payment of capital gains taxes on the property being relinquished.
An exchange of real property may be structured in a variety of ways depending upon the nature of the transaction, the interest in the real property being exchanged and the timing of the sale of the relinquished property and the purchase of the replacement property. A true exchange (where one property owner exchanges property with another owner) would be the simplest, but is the least common exchange structure (absent strategic maneuvering). In the most common exchange transaction, the tax payer sells property to a third party buyer, subsequently identifying and closing on the purchase of replacement property. There may, however, be situations where the replacement property needs to be acquired prior to the sale of the relinquished property (i.e. in the case of construction of a new facility). This is called a reverse 1031 Exchange.
Almost all 1031 Exchange transactions (except the true exchange mentioned above) require the use of a third party intermediary to, among other functions, hold the proceeds from the sale of the relinquished property until the closing on the purchase of the replacement property. Some title companies and banks have subsidiaries with the capacity to act as 1031 intermediaries. There are also independent intermediary businesses. Your attorney or accountant should be able to refer you to an appropriate intermediary.
Compliance with the specific 1031 requirements is critical to the success of a tax deferred exchange. Failure to comply with such requirements may result in the tax payer losing the tax deferred treatment status. Principally, the replacement property must be of “like-kind” with the relinquished property in both type of property (real property or other investment property), as well as, the nature of the ownership in such property. In addition, there are specific notice and timing requirements for the identification of, and closing on, the purchase of replacement property. It is important to familiarize yourself with the requirements before structuring a 1031 Exchange transaction, so that you do not inadvertently expose yourself to the payment of capital gains taxes.
A properly structured 1031 Exchange may be very beneficial to tax payers (companies and individuals) to defer payment of long term capital gains taxes, especially if the tax payer is relocating to a new facility. Even if the tax payer is down sizing, there may still be tax deferral benefits.