Deferring tax on income or gain is almost as effective a strategy as avoiding it altogether. That's because the value today of a future tax obligation is much smaller than one you must pay now. The longer you can defer payment, the lower your effective tax rate. And for U.S. taxpayers, there's no better strategy to take advantage of it than with a strategy called a 1031 exchange.
This cryptic name refers to a section of the Internal Revenue Code that lets you defer tax on exchanges of "like-kind" investment property.
Section 1031 lets you defer paying federal capital gains taxes when you sell a investment property and buy another one of "like kind" through an approved exchange transaction. As a bonus, you may be able to deduct tax for depreciation on the new property, without needing to "recapture" depreciation on the one you sell. To have a fully deferred exchange, the property you acquire must be of equal or greater value to the property you sell.
1031 exchanges are amazingly flexible because almost any like-kind investment property can be exchanged: real estate, industrial equipment, business assets, artwork, aircraft, or vessels. For instance, you could exchange raw land for a shopping center, a condo for a coffee shop, or an office building for an apartment complex. But you couldn't exchange an apartment building for, say, a ship.
However, there’s a potentially fatal flaw in any 1031 exchange. And that’s due to the fact that the IRS requires you to hire a middleman called a “qualified intermediary” (QI) to execute the exchange. But if the QI goes bankrupt in the middle of the exchange, you could lose everything—and the IRS could then dun you for capital gains you no longer have the funds to pay for.
This is an increasingly common occurrence. For instance, in one situation I know of, an elderly couple hired a QI company to execute a $1.5 million real estate transaction, representing about $1 million in deferred profits. But before they were able to conclude it, the company declared bankruptcy. Unfortunately, the company hadn’t bothered to put the $1.5 million in any kind of segregated account. The couple lost their entire $1.5 million.
But it gets worse. Since the couple no longer had the $1.5 million to invest in real estate, they could no longer meet the IRS requirements for Section 1031. That means they could no longer defer taxes on their $1 million gain. As a result, they owe about $150,000 in federal taxes and another $75,000 in state taxes. Not only did they lose their entire nest egg, but they also owe $225,000 in taxes to boot!
What if the exchange company had used a segregated account? In a recent bankruptcy case, it turns out that it wouldn’t have made any difference!
In November 2008, a billion-dollar company called LandAmerica declared bankruptcy. At the time, LandAmerica was handling nearly 500 exchanges with a value of approximately $450 million. And yes, LandAmerica had taken the precaution of setting up a separate entity to segregate 1031 funds.
However, a bankruptcy judge has now ruled that the fact that the accounts were segregated is irrelevant. Instead, the monies are considered LandAmerica’s own assets and available to its creditors. In the meantime, attorneys on both sides are running up bills of thousands of dollars daily. It’s not likely that the folks who engaged LandAmerica will be able to recover much, if anything, once the attorneys have finished their feeding frenzy off the company’s carcass. The latest estimate is they’ll recover about 15 cents for every dollar LandAmerica held on their behalf. And every one of them has lost not only their hard-earned nest eggs, but will no longer qualify for a tax-deferred exchange.
What’s the answer? 1031 exchanges remain one of the most effective ways to defer capital gains taxes in the U.S. Tax Code. However, it’s not enough to use a segregated account. According to the 1031 regulations, instead of a QI, you can also use a “qualified trust.” If you’re not 100% sure of the financial stability of your QI partner, this is now the preferred strategy.
Copyright © 2009 by Mark Nestmann
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