Tax-Free Exchanges



Advance tax planning often properly postpones until tomorrow what normally is considered today’s tax liability.  Internal Revenue code Section 1031 (commonly known as the like-kind exchange or LKE section) contains one method of taxpayer may use to defer today’s tax bill.

What is an exchange?
IRC Sec. 1031 states:  “No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment”.

The tax difference between a sale and an exchange.  Before discussing the ramifications of a tax-free exchange, let us examine the taxation of a taxable sale

Example of what you do not want to do:
Sebastian owns an apartment house (on leased land) in Orlando, which he purchased for $100,000.  The property has a fair market value of $225,000 on December 1, 2005. He has taken $75,000 of straight-line depreciation since his purchase.  He wants to sell it and buy an apartment house in Tampa Bay that has a fair market value of $225,000.  His taxable gain when he sells the Orlando property would be $200,000 calculated as follows:

Sale Price   $225,000
Less: Adjusted Basis    
Original Cost $100,000  
Minus: Depreciation -$75,000  
Adjusted Basis   -$25,000
Equals: Long-term Capital gain   $200,000

TAX DUE ON SALE: Sebastian’s tax, assuming he is in the 28% tax bracket, would be around $30,000 of unnecessary taxes. YIKES!!!!!!!!

So we know a sale and subsequent reinvestment of proceeds, instead of an exchange, will result in Sebastian taking a $30,000 dollar hit on taxes, not good.  To add to the drama add the state taxes and you get the big picture of taxes you can save with a 1031 tax free exchange.

Example of what you do want to do

No tax due on this exchange:  Instead of selling, Sebastian trades his $225,000 Orlando apartment house for the $225,000 Tampa Bay apartment.  None of the $200,000 gain is recognized on Sebastian’s tax return, he would have to report the tax free exchange on his tax return, thereby saving at least $30,000 in federal taxes. 

Saving taxes in not the only benefit!!!  By exchanging, an investor not only saves taxes but can use this increase of their net worth, or equity, to acquire additional real estate.  Coupled with the magic of leverage, this creates dramatic results. 

Example of what you do want to do: 
Using an 80%  loan-to-value ratio, Sebastian can use the $30, 000 tax savings as a 20% down payment to acquire over $200,000 of additional real estate!!!  Of course, he would have to structure the acquisition as part of the above exchange.