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Posted over 9 years ago

Overview of Tax Deferral and Exclusion Strategies

There are many tax-deferral and tax-exclusion strategies available for individuals, corporations and institutions to employ in order to efficiently manage and reduce their income tax liabilities.  It is important for taxpayers to consider all of the options that are available to them before proceeding with a specific tax-deferral or tax-exclusion strategy.

This concise overview of some of the available tax-deferral and tax-exclusion income tax strategies will assist you in evaluating the various tax options available to you and prepare you for your conversation with your legal and tax advisors. 

Section 1031 — 1031 Exchange of Property Held for Investment

Section 1031 of the Tax Code ("1031 Exchange") provides that property held as rental, investment or business use ("relinquished property") can be exchanged for property that is also held as  rental, investment or business use property ("replacement property") thereby allowing investors to defer their Federal, and in most cases, state capital gain, depreciation recapture and Medicare Surcharge ("Obamacare tax") taxes.

1031 Exchanges are tax-deferred transactions and not tax-free transactions as many speakers, authors and advisors frequently refer to them.  Your capital gain, depreciation recapture and Medicare Surcharge taxes are deferred into the acquired replacement property.  The taxes can be continually and indefinitely deferred into replacement properties when they are acquired as part of a series of 1031 Exchange transactions (e.g., you continually 1031 Exchange through out your lifetime and then leave the properties to your heirs).

The tax-deferral benefits of the 1031 Exchange allow taxpayers to sell, dispose, convert or exchange real estate without reducing his or her cash position ("equity") by paying capital gain, depreciation recapture and Medicare Surcharge ("Obamacare") taxes.  This provides the taxpayer with the continued liquidity necessary to increase his or her investment real estate portfolio by trading up in value and ultimately increasing his or her net worth by improving cash flow and capital appreciation from the portfolio.

A Qualified Intermediary, also referred to as an Accommodator, is required when structuring a 1031 Exchange transaction.  Section 1031 of the Internal Revenue Code applies to personal property (i.e., non-real estate) as well as real property.

Section 1032 — Exchange of Corporation Stock for Property

Section 1032 of the Tax Code ("1032 Exchange") provides that no gain or loss will be recognized by a corporation on the receipt of money or other property in exchange for other common stock (including treasury stock) of such corporation.

The 1032 Exchange does not apply to real estate and there is no need for a Qualified Intermediary or Accommodator.

Section 1033 — Involuntary Conversion (Eminent Domain or Natural Disaster)

Section 1033 of the Tax Code ("1033 Exchange") provides that real estate that is involuntary converted or taken via an eminent domain proceeding by a local, state or Federal government, in whole or in part, or via a natural disaster, can be exchanged on a tax-deferred basis for replacement real estate that is "similar or related in service or use" to the property that was involuntarily taken.

You have up to two (2) years to replace property destroyed by a natural disaster, sometimes referred to as an Act of God, and up to three (3) years to replace property taken via an eminent domain proceeding.  Qualified Intermediaries are not required when structuring a 1033 Exchange.

Section 1034 — Rollover of Gain from Sale of a Primary Residence (REPEALED)

Section 1034 of the Tax Code ("1034 Exchange") was repealed in 1996 and replaced by Section 121 of the Tax Code.  It is important to understand what Section 1034 was all about, what changed with the repeal of this Section of the Tax Code and what the differences are between the old and new laws.

Section 1034 of the Tax Code allowed a homeowner of real estate that was used as his or her primary residence to sell or otherwise dispose of his or her primary residence and defer all of his or her capital gain by acquiring another primary residence of equal or greater value and subsequently rolling over the taxable gain.  Qualified Intermediaries are not required for 1034 Exchanges.

Section 1035 — Exchange of Life Insurance, Endowment or Annuity Contracts

Section 1035 of the Tax Code ("1035 Exchange") allows owners of life insurance, endowment, or annuity contracts or policies to exchange or swap these contracts for other life insurance, endowment, or annuity contracts or policies and defer the income tax consequences.  1035 Exchanges do not apply to real estate and there is no need for a Qualified Intermediary.  Generally, life insurance companies can administer the 1035 Exchange in house.

Section 721 — Exchange of Property  Into  A Real Estate Investment Trust (REIT)

Section 721 of the Tax Code ("721 Exchange" or "721 Contribution") allows taxpayers to exchange rental or investment real estate for shares in a Real Estate Investment Trust (REIT).  This is often referred to as a 721 Exchange — also known as an upREIT or 1031/721 Exchange.

You would typically utilize the upREIT in conjunction with selling relinquished property and acquiring replacement property pursuant to a 1031 Exchange.  Once the replacement property has been held as rental or investment property for a sufficient period of time in order to demonstrate the taxpayers intent to hold the property for rental or investment purposes and qualify for 1031 Exchange treatment, the replacement property is contributed into a Real Estate Investment Trust (REIT) in exchange for shares of stock ("equity") in the Real Estate Investment Trust (REIT) pursuant to Section 721 of the Tax Code.

The 721 Exchange or 721 Contribution does not have to be in conjunction with a 1031 Exchange.  The taxpayer could simply contribute rental or investment property already owned by the taxpayer directly into the Real Estate Investment Trust (REIT) in return for an equity position in the REIT as part of a 721 Contribution.

The 721 Exchange or 721 Contribution can provide a taxpayer with a great exit strategy by exchanging out of his or her investment real estate portfolio and into shares of a Real Estate Investment Trust (REIT) that should provide more liquidity once the Real Estate Investment Trust (REIT) is publicly traded. 

The 721 Exchange or 721 Contribution essentially eliminates the ability for the taxpayer to 1031 Exchange back into real estate and defer his or her capital gain taxes because the taxpayer now owns securities instead of a real estate interest.  The taxpayer is also subject to recognition of their taxable gain should the REIT decide to sell (and not 1031 Exchange) the subject property. 

Section 453 — Capital Gain Deferred with an Installment Sale Carry Back Note

Section 453 of the Tax Code ("Installment Sale Treatment") allows taxpayers to defer their taxable gain when they sell and carry back a promissory note or installment note on the disposition (sale) of their relinquished property.  This structure is often referred to as a seller carry back note, seller carry back financing or installment sale treatment. 

Seller Carry Back Financing

Generally, taxpayers would sell their property and carry back a promissory note to help the buyer finance the acquisition of your property.  The taxpayer is then able to defer the recognition of their capital gain, but not depreciation recapture, until principal payments are received by the taxpayer over the term of the promissory note. 

Section 121 — Exclusion of Capital Gain on the Sale of Primary Residence

The Taxpayer Relief Act of 1997 ("The 1997 Act") repealed and replaced the tax deferral "rollover" provisions contained within Section 1034 of the Tax Code with a tax-free capital gain exclusion provision pursuant to Section 121 of the Tax Code ("121 Exclusion").

Taxpayers can sell real property owned and used as their primary residence and exclude from their taxable income up to $250,000 in capital gain per taxpayer ($500,000 for a married couple). 

Taxpayers are required to have (1) owned and (2) lived in the real property as their primary residence for at least a total of 2 years out of the last 5 years.  The 2 years do not need to be consecutive.  There are certain exceptions to the 24 month requirement when a change of employment, health, military service or other unforeseen circumstances have occurred.

The 121 Exclusion is effective for sales of real estate held as a primary residence after May 7, 1997.  Taxpayers can complete a 121 Exclusion every two (2) years.

Taxpayers should carefully monitor the amount of “built-up” capital gain they have in their primary residence and may want to seriously consider selling their primary residence before the capital gain exceeds the $250,000 or $500,000 limitation.  Taxpayer’s capital gain in excess of these exclusion limitations will be taxable.  A sale of the primary residence would preserve the tax-free exclusion of the capital gain and would allow the Taxpayer to acquire another primary residence and start all over again.

Special legal, tax and financial planning is highly recommended in circumstances where a Taxpayer already has a significant capital gain in excess of the $250,000 or $500,000 exclusion limitation.  For example, the primary residence could be converted to rental or investment property and then sold as part of a 1031 Exchange after it has been rented for a sufficient amount of time in order to demonstrate the taxpayer's intent to hold the property as rental or investment property.  This would allow the taxpayer to dispose of his or her primary residence, exclude or defer all of the capital gain, and diversify and allocate the capital gain proratably over a number of rental properties clearing the way for further financial, tax and estate planning opportunities.

There are special rules applicable to real property acquired initially as replacement property through a 1031 Exchange transaction and then subsequently converted to the taxpayer’s primary residence and sold pursuant to a 121 Exclusion.

Other Tax-Deferral and Tax Exclusion Strategies

Charitable Remainder Trusts permit you to transfer your highly appreciated property or asset into a Charitable Remainder Trust (CRT) for the benefit of charities selected by you.  The CRT provides you with an immediate income tax deduction for the "donation" of the property or asset into the CRT, allows you to immediately sell the real property without incurring any capital gain, depreciation recapture or Medicare Surcharge, and then reinvest the net sales proceeds into investments providing better cash flow opportunities.  There are different types of CRTs, so you should discuss your options with your legal, tax and financial advisors.



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