A like-kind exchange, also known as a Section 1031 exchange after the section of the Tax Code that governs it, is essentially a tax-deferral tool that postpones tax on the exchange of a property for another property of a “like kind.”
There are many reasons to consider a like-kind exchange as a tax planning tool, and CPAs are “tremendously involved” in the planning and execution of them, according to Steve Breitstone, partner and head of the tax practice at Mineola, N.Y.-based Meltzer Lippe. “Accounting firms are very active in helping their clients plan for the sale of property and structuring 1031 exchanges and other ways of deferring tax,” he said.
To assess the advantages of doing a like-kind exchange, Breitstone recommends looking at how much tax you will have to pay if you don’t do an exchange on the sale of the property.
“It could be a function of how long you’ve held it, how low is the cost basis and also whether there are liabilities in excess of basis,” he said. “A 1031 exchange can help avoid having to pay tax on phantom gain even where there’s not a clear cash realization event.”
Breitstone finds talk about like-kind exchanges being “loopholes” to be disturbing. “People are all benefitting from the rise in the real estate market,” he said. “If you were to take away this tax deferral technique, there would be a mass exit from real estate and a significant decline in prices, which would have a major ripple effect on the entire economy. The purpose of allowing non-recognition under Section 1031, like many other non-recognition provisions, is that the money is going back into investment property. Is it better to have it reinvested, or go to the government?”
Although a 1031 exchange can have many advantages, there a number of avoidable mistakes that investors—and their advisors—often make, Breitstone observed. “The biggest mistake is overpaying for replacement properties,” he said. “If a buyer alerts the seller and broker that he or she is looking for a replacement property, they may jack up the price because they know the buyer is up against the wall with a tight time frame.
Another mistake is depositing your exchange money with the wrong qualified intermediary. “If you don’t make the right choice, you could lose your money,” Breitstone cautioned. “A first step is to make sure you set up a separate account that can only be released with your signature and the intermediary’s signature at a reputable institution.”
Don’t utilize a real estate attorney—but do use a tax attorney, Breitstone indicated. “Although you’re exchanging real estate, a 1031 exchange is a tax transaction as much as a real estate transaction, if not more so,” he said. “If the exchange is not done properly, the tax consequences can be significant.”
”Another mistake is buying something that doesn’t make sense, just to get a 1031 exchange,” he said. “Sometimes a client is better off leasing the property other than buying another.”
Like-kind exchanges are so formalistic that if you make a mistake, you can easily jeopardize the whole exchange, Breitstone observed. “When you close, there are expenses and adjustments paid at the closing. Mistakes such as showing the wrong figures on your closing statement can precipitate a big taxable event,” he said.
A common misconception is that a 1031 exchange eliminates taxes, Breitstone noted. “The 1031 just defers taxes and, if not done appropriately, can change income from capital gains to ordinary income, subjecting that income to a much higher tax rate as well as other taxes,” he said.
“An easily avoidable mistake is running out of time or buying something that doesn’t make sense to own. The seller looking for an exchange only gets 45 days after closing to identify a replacement property. If the exchanger hasn’t done the due diligence, or the replacement property is sold to someone else, or you don’t have a contract within that time period, you’re out of luck.”
Tax planning is crucial, he emphasized. “A 1031 exchange requires that past, present and future planning be taken into consideration to minimize tax and economic consequences.”
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