THE IRS IS HANDING OUT INTEREST-FREE LOANS TO SAVVY INVESTORS
Whether it’s called barter, trade, or swap, the 1031 exchange is one of history’s oldest types of economic transactions. Where each side receives equal value for what it relinquishes the exchange is a model of economic efficiency. The Internal Revenue Code recognizes this efficiency by allowing a taxpayer to defer the payment of taxes normally payable upon the sale of property when that property is effectively exchanged for property of the same kind that is held for productive use in a trade or business or for investment. The gain is viewed as not having yet been realized, because the exchanging taxpayer has not been paid for the relinquished property.
A 1031 exchange (named for Section 1031 of the Internal Revenue Code), also known as a like kind exchange, affords the exchanging taxpayer greater investing power by deferring the payment of taxes; it essentially functions as an interest-free loan of the taxes for capital gains and depreciation recapture that would otherwise be due. There is no limit on the number of 1031 exchanges a taxpayer can execute. A taxpayer could, therefore, engage in one exchange after another over many years, continuing to defer payment of taxes along the way, thereby allowing the taxpayer to continue to invest what would otherwise be a tax payment.
A 1031 exchange defers not only the payment of taxes on any gain from the transaction. It also defers the payment of taxes on depreciation recapture for the like kind property. A taxpayer takes depreciation deductions to reflect the reduction in the value of property over time as a result of use, wear, or obsolescence. This reduces the taxable valuation of the property, known as its tax basis, by the amount of the depreciation deductions taken. If the property is ultimately sold for more than its diminished basis, depreciation recapture tax is due on the difference between the sale price of the property and its basis. This has the effect of requiring the taxpayer to “pay back” the tax benefits gained from depreciation on earlier tax returns. In a 1031 exchange, payment of this kind of tax liability is deferred for the like kind property because it is not actually sold. It is merely exchanged.
Any owner of investment or business property – including limited liability companies (LLCs) – can take advantage of a 1031 exchange. The LLC offers a number of benefits that are attractive to members and to lenders who might finance the investments of an LLC: flexibility in formation and operation, protection against personal liability for the LLC’s debts and judgments, and the option to have taxation “pass through” to the LLC’s members. For the LLC, the 1031 exchange can be an attractive mechanism for conducting transactions involving both real and personal property and deferring payment of taxes on any gain from the exchange, as well as those arising from depreciation recapture.
- Rob Connallon & Robert Elam