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Summary of Tax Deferral and Tax Exclusion Strategies

There are numerous tax-deferral and tax-exclusion income tax strategies available to individuals, corporations and institutions.   It is important for you to consider all of the available options before proceeding with a specific tax-deferral or tax-exclusion income tax planning strategy.

This concise overview of some of the available tax-deferral and tax-exclusion income tax strategies will assist you in evaluating the various tax options available to you and prepare you for your conversation with your legal and tax advisors. 

Section 1031 — 1031 Exchange of Property Held for Investment

Section 1031 of the Internal Revenue Code ("1031 Exchange") provides that property held as rental or investment property or property used in your business ("relinquished property") can be exchanged for "like-kind" property also held as rental or investment property or property used in your business ("replacement property") allowing you to defer your Federal, and in most cases, state capital gain and depreciation recapture income tax liabilities.

It is important to note that 1031 Exchange transactions are tax-deferred exchanges — not tax-free exchanges — as many speakers, authors and advisors frequently refer to them.  Your capital gain and depreciation recapture income tax liabilities are merely deferred — and can be continually and indefinitely deferred — into like-kind replacement properties acquired as part of a series of 1031 Exchange transactions.

The tax deferral benefits of the 1031 Exchange allow a Investor to sell, dispose or convert real property without reducing his or her cash position by paying capital gain or depreciation recapture taxes.  This provides the Investor with the continued liquidity necessary to increase his or her real estate portfolio by trading up in value and ultimately increasing his or her net worth by improving cash flow and capital appreciation from the portfolio.

A Qualified Intermediary is required when completing a 1031 Exchange transaction.  Section 1031 of the Internal Revenue Code applies to personal property as well as real property.

Section 1032 — Exchange of Corporation Stock for Property

Section 1032 of the Internal Revenue Code ("1032 Exchange") provides that no gain or loss shall be recognized to a corporation on the receipt of money or other property in exchange for stock (including treasury stock) of such corporation.

This type of exchange transaction does not apply to real estate and there is no need for a Qualified Intermediary.

Section 1033 — Involuntary Conversion (Eminent Domain or Natural Disaster)

Section 1033 of the Internal Revenue Code ("1033 Exchange") provides that real property that is or will be the subject of a compulsory or involuntary conversion either from condemnation via an eminent domain proceeding by local, state or Federal government, in whole or in part, can be exchanged by you on a tax-deferred basis for "like-kind" real property that is similar or related in service or use to the property that was involuntarily converted.

You have up to two (2) years to replace property destroyed by a natural disaster, sometimes referred to as an Act of God, and up to three (3) years to replace property converted because of a condemnation via eminent domain proceeding.

A Qualified Intermediary is not required when completing a 1033 exchange transaction.

Section 1034 — Rollover of Gain from Sale of a Primary Residence (REPEALED)

Section 1034 of the Internal Revenue Code ("1034 Exchange") was repealed and replaced by Section 121 of the Internal Revenue Code.   However, it is important to understand what Section 1034 was all about, what changed with the repeal of this Section and what the differences are between the old and new laws.

Section 1034 of the Internal Revenue Code allowed an owner of real property that was used as his or her primary residence to sell or otherwise dispose of the primary residence and defer 100% of his or her capital gain tax liability by acquiring another primary residence of equal or greater value.

Qualified Intermediaries were not required for Section 1034 exchange transactions.

Section 1035 — Exchange of Life Insurance, Endowment or Annuity Contracts

Section 1035 of the Internal Revenue Code ("1035 Exchange") allows owners of life insurance, endowment, or annuity contracts or policies to exchange or swap these contracts for other life insurance, endowment, or annuity contracts or policies and defer the income tax consequences.

This type of exchange transaction does not apply to real estate and there is no need for a Qualified Intermediary. 

Section 721 — Exchange of Property Into A Real Estate Investment Trust (REIT)

Section 721 of the Internal Revenue Code ("721 Exchange") allows you to exchange your rental or investment real estate for shares in a Real Estate Investment Trust (REIT).  This is called a 721 exchange — also known as an upREIT or 1031/721 exchange.

You would typically utilize the upREIT in conjunction with selling relinquished property and acquiring like-kind replacement property pursuant to Section 1031 of the Internal Revenue Code.  Once the replacement property has been held as rental or investment property for 12 to 18 months or more in order to demonstrate the Investors intent to hold the property and qualify for 1031 Exchange treatment, the replacement property is contributed into a Real Estate Investment Trust (REIT) in exchange for shares of stock in the Real Estate Investment Trust (REIT) pursuant to Section 721 of the Internal Revenue Code.

The 721 exchange does not have to be in conjunction with a 1031 Exchange, however.  The Investor could simply contribute rental or investment property already owned by the Investor directly into the Real Estate Investment Trust (REIT) as part of a 721 exchange.

The 721 exchange can provide a Investor with a great exit strategy by exchanging out of his or her investment real estate portfolio and into shares of a Real Estate Investment Trust (REIT) that should provide more liquidity once the Real Estate Investment Trust (REIT) becomes publicly traded and listed on a securities exchange.  The Investor also gains complete control and flexibility over the recognition of the capital gain tax by determining the timing and the quantity of shares sold in the Real Estate Investment Trust (REIT).

However, the 721 exchange essentially eliminates the ability for the Investor to exchange back into real estate and defer his or her capital gain taxes by using a 1031 Exchange because the Investor now owns securities instead of a real estate interest.

Section 453 — Capital Gain Deferred with an Installment Sale Carry Back Note

Section 453 of the Internal Revenue Code ("Installment Sale Treatment ") allows you to defer your capital gain income tax liabilities when you carry back a promissory note or installment note on the disposition (sale) of your property.  This structure is often referred to as a seller carry back note, seller carry back financing or installment sale treatment. 

Seller Carry Back Financing

Generally, you sell your property and carry back a promissory note to help the buyer finance the acquisition of your property.  You are then able to defer the recognition of your capital gain income tax liabilities until principal payments are received by you over the term of the promissory note. 

Structured Sales

The sale of your property can also be set-up as a Structured Sale.  You sell your property and in return receive an annuity.  You receive payments from the annuity over a period of time selected by you.  You recognize your capital gain on a prorata basis as you receive principal payment from the annuity.  There is no IRS guidance for the Structured Sale, Deferred Sales Trust or Self-Directed Installment Note at this time. 

It is extremely important to note that depreciation recapture is not be deferred under an installment sale structure and will be recognized in the year in which the disposition (sale) occurred. 

Section 121 — Exclusion of Capital Gain on the Sale of Primary Residence

The Taxpayer Relief Act of 1997 repealed and replaced the tax deferral "rollover" provisions contained within Section 1034 of the Internal Revenue Code with a tax-free capital gain exclusion provision pursuant to Section 121 of the Internal Revenue Code ("121 Exclusion").

Generally, a Taxpayer can sell real property held (owned) and used (lived in) as his or her primary residence and exclude from their gross income up to $250,000 in capital gains per taxpayer and up to $500,000 in capital gains if the taxpayer is married and filing a joint income tax return. 

The Taxpayer is required to have (1) owned and (2) lived in the real property as his or her primary residence for at least a combined total of 24 months out of the last 60 months (two out of the last five years).  The 24 months do not need to be consecutive.  There are certain exceptions to the 24 month requirement when a change of employment, health, military service or other unforeseen circumstances have occurred.

Section 121 is effective for dispositions (sales) of real property held as a primary residence after May 7, 1997.  Taxpayers can complete a 121 exclusion once every two (2) years.

Taxpayers should carefully monitor the amount of “built-up” capital gain in their primary residence and may want to seriously consider selling their primary residence before the capital gain tax liability exceeds the $250,000 or $500,000 limitation.  The Taxpayer’s capital gain tax liability in excess of these exclusion limitations will be taxable.  A sale of the primary residence would preserve the tax free exclusion of the capital gain and would allow the Taxpayer to acquire another primary residence and start all over again.

Special legal, tax and financial planning is needed in circumstances where a Taxpayer already has a significant capital gain tax liability in excess of the $250,000 or $500,000 exclusion limitation.  For example, the primary residence could be converted to rental or investment property and then sold as part of a 1031 Exchange after it has been rented for a sufficient amount of time in order to demonstrate the Investor’s intent to hold the property as rental or investment property.  This would allow the Taxpayer to dispose of his or her primary residence, defer all of the capital gain tax liability, and diversify and allocate the capital gain tax liability proratably over a number of rental properties clearing the way for further financial, tax and estate planning opportunities.

There are special rules applicable to real property acquired initially as replacement property through a 1031 Exchange transaction and then subsequently converted to the Taxpayer’s primary residence and sold pursuant to Section 121 of the Internal Revenue Code.

Other Tax-Deferral and Tax Exclusion Strategies

Charitable Remainder Trusts permit you to transfer your highly appreciated property or asset into a Charitable Remainder Trust (CRT) for the benefit of charities selected by you.  The CRT provides you with an immediate income tax deduction for the "donation" of the property or asset into the CRT, allows you to immediately dispose of (sell) the property or asset without incurring any depreciation recapture or capital gain income tax liabilities, and then reinvest the net sales proceeds into investments providing better cash flow opportunities.  There are different types of CRTs, so you should discuss your options with your legal, tax and financial advisors.

There was once a signifant amount of discussion regarding Private Annuity Trusts.  However, the Internal Revenue Service (IRS) effectively eliminated the Private Annuity Trust (PAT) as a tax-deferral option in late 2006.  The Private Annuity Trust has been replaced with the Deferred Sales Trust and the Structured Sale

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