1031 Exchanges And the Tax Advisor

Prior to engaging in an 1031 exchange, it is critical that the taxpayer consult with his tax and/or legal advisors regarding the transaction. There may be very specific reasons why the tax advisor either recommends the exchange or recommends paying the taxes. It is impossible for us (both the Qualified Intermediary (QI) and the agent) to know how the 1031 exchange will affect the overall tax consequences for an individual taxpayer because we don't know their tax picture.

In addition, the CPA is the person who will be accompanying the taxpayer to any audit and it is critical that the advisor be involved with the transaction from the very beginning.

For example: A tax advisor may advise the taxpayer to take the capital gain (not do a 1031 exchange) because the taxpayer has a huge carry over loss that he will not be able to take advantage of over time. He may be able to use the capital gain to offset the carry over loss. This allows the taxpayer to sell the appreciated property, recognize the gain on his taxes and still get the benefit of the carry over loss without having to comply with the time restrictions of an exchange.

For example: You have been consulted by the seller of single family residence that he has rented for the last two years but the sale price is less than what he paid for it. On the surface, this does not look like a 1031 scenario because of the lack of appreciation. However, what he hasn't told you yet, is that he purchased it in a 1031 exchange, so his net adjusted basis is not (purchase price + capital improvements - depreciation) it is calculated like this (purchase price - (capital gain deferred) + capital improvements - depreciation).

Simplified Example 

2000 Bought 1st Rental

$150,000

2005 Sold 1st Rental

$250,000

Capital Gain  (without capital improvement and depreciation calculation ) = $100,000

2000 Taxpayer does an Exchange to defer the capital gain tax due on the $100,000

Buys 2nd Rental for $400,000

2007 Sells 2nd Rental for $325,000

Looks like there's no capital, right?

There is capital gain of $25,000.

When he purchased the 2nd rental for $400,000 his basis was reduced by the $100,000 that he deferred, so his basis in the 2nd rental is actually $300,000. The second rental sold for $325,000, so there is a $25,000 capital gain issue.

This explanation was highly simplified (an accountant will be taking in a number of factors to determine the true capital gain tax liability) to show you that "all is not what it appears" in the 1031 exchange world. Consult a reputable Qualified Intermediary like Asset Preservation for additional guidance.  www.apiexchange.com

THIS INFORMATION IS PROVIDED FOR EDUCATIONAL AND INFORMATIONAL PURPOSES ONLY. TAXPAYERS ARE ADVISED TO SEEK THE ADVICE OF THEIR TAX AND LEGAL PROFESSIONALS.