The Benefits and Pitfalls of Like Kind Exchanges

by John Meara

You might not want to hear the words "Internal Revenue Service" at this time of year, but Internal Revenue Code 1031 provides a neat way of deferring ordinary income and capital gain tax on the sale of commercial real estate. If you exchange the property for like kind property, you are allowed to reduce basis in the acquired property (which reduces future depreciation) rather than paying the tax currently.

So why is tax deferral so alluring? Let’s refer to a typical IRA deferral chart.

If you invest $1,000 in a tax-deductible IRA, the entire $1,000 (represented by green) is preserved for investment. Alternatively, if tax is paid on that $1,000, the net available for investment is only $600 (represented by blue). If the 5 percent assumed earnings rate is tax deferred, the $1,000 will grow to $2,527 in 20 years. The taxed investment only grows at a 3 percent rate (5 percent less a 40 percent tax rate), so it only grows to $1,084 in 20 years. Even if the $2,527 IRA proceeds are taxed at 40 percent 20 years from now, the result is $1,592 for the tax-deferred IRA compared to $1,084 for the taxable investment. That makes a pretty compelling argument for tax deferral.

Now let’s see how a 1031 exchange can offer even greater advantages. One big advantage is that if you never sell but hold the property until death, you’ll not only defer the tax, but avoid nearly all of the tax. In addition, your heirs can receive a step up in basis to fair market value. (This is under current estate tax law, which could expire in 2010.)

So let’s look at the chart that explains the tax deferral benefits of a 1031 exchange.

The chart clearly shows that the benefit of the 1031 tax deferral is nearly eliminated by the tax value of the lost depreciation over the life of the property. This is true despite the conservative assumptions used. For example, 40-year, straight-line depreciation could have been as little as 25 years using accelerated component depreciation. Pages of calculations and assumptions were used in generating the above chart. So the bottom line is to plan before engaging in a 1031 exchange.

Also, beware of some of the hidden pitfalls in a 1031 exchange:

- Substantial fees in the transfer (agents, lawyers—yes, even accountants) can reduce the expected benefits making the transaction unprofitable.

- Often substantial premiums must be paid to attract sellers of property to engage in 1031 exchanges.

- Current tax rates are at historical lows (particu-larly capital gains at 15 percent). The rates are likely to increase in the future and could greatly reduce expected benefits.

- 1031 exchanges can and do fail, which can result in costly litigation. After all, a 1031 involves two properties, which doubles the potential deal killers.

Even if you read and understood every word of this article, I suggest you engage extremely competent legal and accounting assistance if you intend to engage in the highly complicated and often tricky provisions of a 1031 exchange. But the benefits can be substantial.

 

John Meara provides professional counsel in accounting, tax, valuation and fraud issues at Meara, King & Co. He can be reached by phone at 816.561.3838 or by email at john@meara.com.