The majority of our clients and referral sources are aware that doing a Section 1031 tax deferred exchange allows Taxpayers the privilege of deferring the payment of their federal capital gains taxes, depreciation recapture taxes and state income taxes (if any) on the property they held for investment or on the property that they used in their trade or business.
So, deferral of payment of taxes is a major reason astute Taxpayers use Section 1031 of the Internal Revenue Code. But there are numerous Non-Tax reasons to do a 1031 exchange. I will try to cover some of these reasons in this 1031 information missive. Let’s begin: Non-Tax reasons to do a Section 1031 Exchange:
1. Taxpayers may want to sell a property that they have fully depreciated and exchange into a more expensive property that can have additional depreciation.
2. Taxpayers may want to exchange a property that is not producing income into a piece of property that does produce an income stream. A typical example would be the exchanging of a piece of raw acreage into a replacement property, such as an office building, that would produce a positive cash flow. A lot of retirees do this type of exchange, because they are looking for an additional income stream in their retirement years.
3. Taxpayers’ “Property of Their Dreams,” becomes available and so they exchange an investment property they are not particularly fond of for the “Property of Their Dreams.”
4. Taxpayers exchange a property that is not producing a satisfactory cash flow for another that will produce a larger cash flow.
5. Taxpayers want to diversify their investments. They might own one large property. They could sell the large property (relinquish it) and purchase (replace) with numerous investment properties. They may want to diversify because they would like to have properties in various different states, so that if one state has an economic problem, the rest of their assets are not affected. Or they might want to own different types of property. For example, they could exchange a large office building and replace it with a small strip shopping center, an office condominium, and other property–all being different types of real estate. Remember–the property sold (relinquished) must be “like kind” to the property purchased (replaced). In the case of real estate, all investment real estate is “like kind” to any other type of investment real estate.
6. The Taxpayers may want to exchange a property that is not appreciating at the rate they would like for another property that has a better possibility for increased appreciation.
7. The Taxpayers may decide to do a 1031 exchange because the present property they own may be harder to sell in the future and the replacement property may be easier to dispose of in the future.
8. The Taxpayer decided to relocate to another state and would like to have all of their investments within a reasonable distance from where they live. This becomes especially important to the Taxpayer who must manage and oversee their investments personally.
9. Consolidation is an important concern to many of our clients. They own a number of investment properties and managed them for a number of years. They have decided that it would be better to own fewer, but more expensive investments. This could decrease the Management responsibilities, as a larger/more expensive property is more conducive for hiring a management company to take care of the investment.
10. Multiplication and Leverage–no I’m not talking about 3 x 3 = 9. Many Taxpayers are hoping that through their investments, their net worth will appreciate. For example: A Taxpayer who owns a piece of property valued at $500 that will appreciate 10% in a year, will have an investment worth $550 at the end of the first year (appreciation of $50 that year). A Taxpayer who exchanges that $500 (I am presuming there is no debt on the property to make this example easy to understand) for a $2,000 investment (that would be 25% down–$500–with the remaining $1,500 in borrowed money) would have at a 10% appreciation factor, a $200 appreciation that year. We know which is more–$200 is more than $50. So, through multiplication and Leverage–the Taxpayer’s net worth can appreciate at a much quicker pace.
11. Reduced Management Responsibilities–I know I have intimated this reason above, but it is a very important reason that many Taxpayers transact a 1031 exchange. They exchange the property they presently own and replace it with one with less management headaches, or replace it with a property that they don’t have to manage at all, such as a Tenant-in-Common/Delaware Statutory Trust type of property–that is professionally managed by others.
12. Exchange out of a property they own a partial interest in–and exchange into a property they will own just by themselves. That way they no longer have to get an approval to do anything to or with the property from their “co-owner.”
13. Estate Planning is a major reason Taxpayers should do a Section 1031 exchange. Although this 1031 Information Missive is titled Non-Tax Reasons–I just had to sneak this one in because, if done correctly, most Taxpayers will pay NO tax when doing a Section 1031 exchange and at the Taxpayers’ demise, their heirs will receive these assets at a stepped-up basis—-and it’s very likely that there will be no estate taxes.
Courtesy of: Liberty 1031