When Would a 1031 Exchange Not Benefit Me?

I get this question quite a bit. Is there ever a situation or time when a 1031 Exchange might not benefit me or would not be such a good idea? The answer, of course, is yes. 1031 Exchanges are complex tax-planning strategies that are not suitable for everyone and are certainly not appropriate under all circumstances.

The sale of any real estate should be carefully evaluated to determine the best and most suitable tax-planning strategy available for each investor. This is why investors should always visit with their legal, tax and/or financial advisors before proceeding with any 1031 Exchange. Advisors can help investors ensure that the 1031 Exchange is the best alternative for their specific situation, goals, and objectives. I cannot emphasize this enough! I know that investors like to do things themselves, and that they hate to pay advisors for their advice and guidance, but a few hundred dollars is well worth it if you can avoid a major headache later. Remember, investors often do not know what they do not know. An advisor can help you understand what you do not know, but need to be wary of.  Your team of advisors should also include a good 1031 Exchange Qualified Intermediary that can help balance each of the advisors opinions.

Having said all of that, you would generally not want to structure a 1031 Exchange transaction for the sale of investment real estate if the sale would generate an actual loss for income tax purposes. You would most likely be better off with selling the property without a 1031 Exchange so that you can recognize and write off the loss from the sale. However, there are limited situations when you might actually want to defer a loss from the sale of property by structuring a 1031 Exchange.

In many cases, an investor’s Adjusted Gross Income, also referred to as his or her AGI, might be high enough that it prevents the investor from taking advantage of his or her passive activity losses on some or all of their investment properties. The outright sale of the investment property may allow them to recognize and take full advantage of the accumulated suspended passive activity losses against other taxable income or gains. It might make more sense in cases like this to just sell a property and use up the suspended activity losses. This requires careful analysis of the investor’s overall income tax position.

Investors may also want to consider a partial 1031 Exchange where they sell property at one value and exchange into or acquire a lesser value property or what we call trading down in value. This would allow them to defer most of their taxable income tax from depreciation recapture and capital gains, but recognize a small amount to strategically offset certain other loss carry forwards. Trading down can also be an effective strategy used to reduce their overall debt service level. It is important not to automatically rush into a 1031 Exchange, but to do some carefully planning to make sure that the 1031 Exchange is the right strategy to meet your specific goals and objectives.

Wondering about the direction of the U.S. economy?

Try this measurement index:  The Augmented Misery Index … the old inflation-plus-unemployment formula minus changes in home prices. Lately it’s ticked down to 7.4, less than half the level of a year ago, and figures to fall further as jobs and housing pick up and prices ease.

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Happy New Year!

The Exeter Learning Institute's team of 1031 Exchange Experts and Advisors would like to wish each and everyone of our readers a very Happy, Healthy and Prosperous New Year.

Did You Buy Substantially The Same Property That You Identified In Your 1031 Exchange?

I know, I know.  You are wondering what I've been drinking.  But, this is a real issue.  In fact, It is a really critical issue when you are being audited.

It does in fact come up during income tax return audits, especially when the California Franchise Tax Board is the audit agency.  The California Franchise Tax Board has been taking very hard look at just this issue.  We've been brought in as 1031 Exchange experts on audit cases for this very issue. 

Actual Case Study
Let's look at an audit case that we recently consulted on.  The investor/taxpayer sold a property ("relinquished property") and structured a 1031 Tax Deferred Exchange transaction.  The investor/taxpayer identified his intended purchase ("replacement property") within the required 45 calendar day identification period.

His identification read like this: 12345 Main Street, Anytown, CA 92345

He made an offer, which was accepted, to buy an undivided ten percent (10%) interest in his identified property, and he actually closed on the purchase of the fractional interest well within his 180 calendar day exchange period.

Acquiring Substantially The Same Property
The issue is this, by identifying the property as 12345 Main Street, he has effectively identified 100% of the property as his intended replacement property.  However, he only acquired a ten percent (10%) interest in the property. 

The question then becomes, did he actually acquire substantially the same property as the property that he identified if he only acquired ten percent (10%) of what he actually identified. 

I know, I know, this is like splitting hairs.  But, the California Franchise Tax Board is taking this very position right now.  They have disqualified the 1031 Exchange under audit because he did not acquire substantially the same property that he identified. 

Investors/taxpayers structuring 1031 Exchanges must be very, very careful when identifying their intended like-kind replacement properties so that they do not run afoul of the hyper-critical taxing authorities today.