Deferred Real Property Exchange
Pros vs Cons
Pro: Defer Payment of Taxes-Indefinitely-Without Penalty or Interest.
By doing a 1031 exchange, a taxpayer may dispose of "property held for productive use in a trade or business or for investment" (which we’ll call "income or investment property"), and acquire replacement income or investment property, without recognition of capital gain in calculating the taxpayer’s income tax. By avoiding recognition of capital gain, the taxpayer defers payment of income taxes, indefinitely at the taxpayer’s discretion, without any penalty or interest coming due to the IRS or state tax authorities.
Pro: Leverage.
By deferring payment of taxes, the taxpayer has additional funds currently available for investment. The effect of this on a taxpayer’s investment choices should be obvious, and will be discussed later.
Pro: Make Government an Investment Partner.
Really just a restatement of the first two points, but some folks think this says it best. By deferring payment of taxes, the taxpayer has use of "the government’s money" to pursue personal income or investment goals.
Pro: Taxes Avoided by Death.
They say you can’t take it with you, but here’s how taxes deferred now can become taxes avoided forever. Under Internal Revenue Code ¤ 1014, upon death all property in the decedent’s estate is entitled to a stepped-up basis for purpose of calculating the heirs’ capital gain upon a subsequent sale. Under this rule, property is valued as of the date of the decedent’s death for purposes of determining its "basis", without regard to when the property was originally acquired or its original basis. This allows an heir to avoid tax liability for all capital gains during a decedent’s lifetime. While in some cases the benefits of this rule may be lessened by federal estate taxes or state inheritance taxes, potential for "stepped-up basis" is an important factor to be considered in anyone’s estate or financial planning.
In sum, the 1031 exchange is an attractive vehicle for deferment of taxes, maximization of income, and accumulation of assets and wealth. This vehicle permits deferment of taxes until a later time, such as retirement, when the taxpayer may be subject to lower tax rates, or after death, when taxes may be avoided by the "stepped-up basis" rule.
So, what are the cons?
Con: Need Tax Advisor.
Each taxpayer’s decision to do, or not to do, a 1031 exchange must be made in the context of his or her investment goals and overall estate plan. This decision begins with consideration of the taxpayer’s current tax liabilities and potential capital gain upon sale of given property. Likewise, the decision must be made in light of the availability of suitable replacement property. Since these decisions may be complicated, and require technical or legal or accounting expertise, taxpayers are cautioned against attempting a 1031 exchange without the guidance of a knowledgeable tax advisor, such as a tax attorney or certified public accountant.
Con: Must Follow Rules and Regulations, and Meet Deadlines.
Current 1031 exchange practices have evolved from federal statutes and court decisions, culminating in Regulations issued by the IRS. These Regulations were written to strike a balance between the competing interests of taxpayer and tax collector, by establishing procedures, deadlines and protocols which, if observed, will cause the taxpayer’s transactions to enjoy "nonrecognition" or tax-deferred status with the IRS.
Con: May be Increased Costs of Transaction.
As explained below, the taxpayer’s observance of IRS Regulations in connection with the 1031 exchange will involve additional transaction costs. In addition to a tax advisor, the taxpayer typically will also need to retain an intermediary, an exchange escrowholder or trustee and, in many cases, an appraiser.
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