1031 Exchanges - Common Pitfalls and How to Avoid Them

This is the first part of a series of articles published to inform exchangers how to avoid common pitfalls when doing 1031 exchanges.

            Make Sure the Exchange is Beneficial from a Tax Perspective

The number of property owners exchanging property under IRC s. 1031 has skyrocketed over the past few years. This is due to a variety of factors including market conditions, and increased awareness of both the advantages of exchanging and the ease of which an exchange can be accomplished. It is important, however, that a taxpayer considering an exchange consult with his or her tax advisor first, to make sure that the exchange makes sense from a tax perspective.

The sale of real estate is generally a taxable event and can produce a taxable gain or loss. The entire gain (or loss) is recognized for federal income tax purposes in the year of sale. There are some important exceptions to this rule, however, including a 1031 exchange. The provisions of 1031 are mandatory - if your transaction meets the requirements of §1031, no gain or loss will be recognized in the year of sale.

A. The value of the property is less than your cost basis. If the value of the property is less than your tax basis, you would realize a loss on the sale. A 1031 exchange in this situation would actually defer the loss on the sale of the property and prevent you from recognizing the loss in the year that it occurred.

B. You have current year losses or loss carryovers (i.e. capital losses, net operating losses, etc.). If you have current losses, these losses may offset, partially or in full, the gain on the sale of your property. From a timing perspective, it may be beneficial to utilize the losses when you can instead of carrying them forward.

C. You have suspended passive losses from the rental property you wish to exchange. These losses will become non-passive and deductible in full in the year you sell your property. These losses can offset any capital gain on the sale of the property.

D. You are in a very high tax bracket and need depreciation deductions. Since any gain deferred through a 1031 exchange reduces the cost basis of your replacement property, your depreciation deductions will also be reduced. If you sell your property, pay the capital gains tax and then buy a replacement property, you will not have to reduce the cost basis of the new property. This may prove to be advantageous, but depreciation deductions are taken over an extended period of time while the tax on the sale will be due in the next tax year.

E. You do not want to reinvest all of the money from the sale of your property in the replacement property. The money you do not reinvest will be considered boot and you will have to pay taxes on it. It may still make sense to do a 1031 in this case, but you must crunch the numbers to see how much tax you will pay on the boot and how much the cost basis of your new property will be reduced by the amount of gain deferred.

In the majority of cases, from a tax savings perspective, the decision to exchange is easy. A taxpayer should, however, review its overall tax situation with a tax professional before exchanging.