Tax Deferred Exchanges

1. While selling considerably appreciated real estate and reinvesting the after-tax proceeds of the sale can be a very attractive move, a tax-deferred property exchange can be much more attractive – especially for high income tax bracket taxpayers.  

2. Taxpayers who are lucky enough to own considerably appreciated real estate can defer paying Federal income tax and the Obamacare surtax on the gain by following statutory and regulatory property-exchange procedures and reinvesting the sales proceeds in replacement real property.  State income taxes would be deferred as well.

3. The taxes levied on a taxable sale are formidable.  The Federal government’s stake in a taxable gain is at least 23.8 percent after giving effect to the 3.8 percent Obamacare surtax.  In many cases, the gain on appreciated property is almost the entire sales price.  Consequently, (with the exception of depreciated property) only 76.2 percent of the sales proceeds might remain in a taxpayer’s bank account after paying what’s due to the U.S. Treasury on a taxable gain.  For property improved with one or more buildings, the Federal tax on the gain can be higher – depending on the extent and type of depreciation deductions taken by the taxpayer over the years.

4. State and municipal income taxes add to the problem.

a. If you’re a resident of a state with an income tax, you’ll be taxed on gains on the disposition of property located anywhere.  Moreover, taxpayers with gains on the disposition of property located in states with income taxes are also subject to the state’s income tax on the gains as well.  Here are some examples: Top-bracket taxpayers pay California 13.3 percent of their gains, Oregon, 9.9 percent, Iowa, 8.98 percent, New Jersey 8.97 percent, DC 8.95 percent, Vermont, 8.95 percent, and New York State 8.82 percent.

b. That’s not all.  Some cities impose income taxes on their residents.  New York City is among them.

5. Taxpayers, especially top-bracket taxpayers, should consider a property-exchange transaction instead of a taxable sale.  The deferral of both Federal and State income taxes on the gain allows the taxpayer to reap the benefits of reinvesting all of the sales proceeds.  It’s an attractive alternative to the significant dilution of the net sales proceeds by virtue of the need to pay combined Federal and state income taxes on the gain that (in some cases) exceeds one-third.

6. The deferral will continue until the replacement real property is sold in a taxable sale.  Yet, a taxpayer who needs to dispose of the replacement property for one reason or another is not forced to do so in a taxable sale.  If a need to dispose of the replacement arises, it can be exchanged for another replacement property in another property-exchange transaction in compliance with IRS requirements.

7. All of this assumes that Section 1031 of the Internal Revenue Code and its regulations aren’t repealed or changed substantially.  Please don’t consider this tax advice.  You should consult your own tax advisor to help you decide whether to sell your property outright or dispose of it pursuant to a tax-deferred property-exchange transaction. 



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