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The Tax Prophet Newsletter   Issue # 25 July, 2005

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In This Issue:
Introduction
Sec. 1031
Real Estate


Tax Free Exchanges
Part 1 of 2


Introduction

Many real estate fortunes can be traced to the skillful exploitation of the tax-free exchange provisions of Interal Revenue Code Section 1031 (Sec 1031). Generally, under Sec. 1031, if a taxpayer transfers property held for investment in a trade or business (investment property) and receives investment property in return (replacement property), there is no immediate tax on the transaction. Tax on the gain is deferred until the replacement property is sold or the taxpayer dies. However, the receipt of cash (including a net reduction on the debt on the relinquished property) or other non-like-kind property is immediately taxable as "boot."

Thus, taxpayers may continue to trade-up properties under Sec. 1031 and postpone income taxes until death, at which time, assets are revalued to fair market value and the deferred income tax obligation disappears (however, the assets may be subject to estate taxes).


Sec. 1031

Generally, IRC Sec. 1031 provides that when investment property is exchanged for "like-kind" investment property, no gain or loss will occur on the transaction. As noted above, any cash or other non-like-kind property received falls outside Sec. 1031 and is immediately taxable.

Note: As Sec. 1031 is used in the real world, the term "exchange" means a special type of sale in which the taxpayer relinquishes property and receives replacement property, rather than the actual sales proceeds.

In a typical transaction, a seller will sell property to a buyer for cash, but will direct the buyer to cooperate with a Sec. 1031 exchange by paying the purchase price into escrow (Escrow 1). The seller then contracts to acquire a replacement property (Escrow 2) and the buyer's funds from Escrow 1 are transferred to Escrow 2.

The result: The buyer in Escrow 1 receives the taxpayer's relinquished property and the taxpayer receives the replacement property from Escrow 2. This is called a simultaneous exchange. If Escrow 2 closes after Escrow 1, then the taxpayer needs to comply with the stringent deferred exchange rules (to be discussed in next month's newsletter).


Real Estate

Sec. 1031 is popular with sophisticated real estate investors because the "like-kind" requirement is liberally interpreted. For example, an exchange of raw land for a condominium, apartment building, warehouse, or a commercial property (or vice-versa) meets the definition of like-kind property. Similarly, a lease of real estate for 30 years or longer is like-kind to outright ownership.

Note: An exchange of investment property for personal property, such as a residence or vacation home (or vice versa) is not covered by IRC Sec. 1031 and is therefore, a taxable transaction.



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All contents copyright © 1995-2005 Robert L. Sommers, attorney-at-law. All rights reserved. This newsletter provides information of a general nature for educational purposes only and is not intended to be legal or tax advice. This information has not been updated to reflect subsequent changes in the law, if any. Your particular facts and circumstances, and changes in the law, must be considered when applying U.S. tax law. You should always consult with a competent tax professional licensed in your state with respect to your particular situation. The Tax Prophet® is a registered trademark of Robert L. Sommers.