1031 Exchange Planning After the 2011 Tax Relief Act

President Obama signed the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2011 (the "Act") into law. This new act has some very favorable income tax planning provisions that benefit owners of real estate assets, and especially for those taxpayers who have always taken advantage of 1031 Exchanges.

The Act extends many areas of former President George W. Bush's tax cuts, including lower capital gain tax rates, tax free exemptions for estate and gift taxes, as well as preserving the step-up in cost basis received by heirs at the date of death.

Capital Gain Tax Rates Extended

The current low capital gain tax rates were extended for two (2) more calendar tax years. This means that most of us will be paying capital gain taxes at the maximum capital gain tax rate of just fifteen percent (15%) through December 31, 2012, unless of course you are deferring your capital gain taxes by structuring a 1031 Tax Deferred Exchange (see Section 1031 of the Internal Revenue Code). The ability to defer capital gain taxes into the future through a tax-deferred exchange such as the 1031 Exchange is often the best strategy because it keeps your money working for you.

Depreciation Recapture and State Taxes

Don't forget to include depreciation recapture taxes and any state income or capital gain taxes in the tax planning computation or estimate. The combined Federal and state taxes are still high on a combined basis for many states, so tax planning is still extremely important.

Estate and Gift Tax Exclusion

The estate and gift tax exclusion will be set at $5 million per taxpayer with any amount in excess of $5 million taxed at 35%. This is certainly more favorable for taxpayers than what many advisors and experts had expected to see out of this lame duck session of Congress.

Step-Up In Cost Basis

Taxpayers often ask what is the best way to plan for the transfer of their wealth at death. The most appropriate and suitable answer is generally to continue to defer their taxes throughout their life time by using tax deferred and tax exclusion strategies such as the 1031 Exchange. This allows the taxpayer's money to keep working, building and growing for him or her.

However, by far, the biggest benefit here is the ability to leave assets to heirs at a step-up in cost basis. This means that essentially the capital gain taxes go away when property is inherited by others. The person that inherits the property gets their new cost basis stepped up to equal the value of the fair market value of the property at the date of death.

Taxpayers can continue to defer capital gain taxes over the years, including depreciation recapture taxes, by structuring 1031 Tax Deferred Exchanges, and then leave the real estate or personal property to their heirs without incurring any capital gain taxes or depreciation recapture taxes. The heirs are only responsible for any capital gain tax or depreciation recapture tax that occurs or is generated after the date of death while they own the asset.

Beyond 2012

Planning for tax years beginning on or after January 1, 2013 is more problematic since these extensions end as of December 31, 2012, but at least we have some certainty for a couple of years.

Capital Gain Tax to Remain at 15%

The U.S. House of Representatives and the U.S. Senate have approved the package of extensions of tax rates and unemployment benefits, sending the legislation to the President for his signature (H.R. 4583, 277-148).


The bill as passed sets the estate tax exemption at $5 million and the rate at 35%, and extends all of the Bush era tax cuts for two years and reduces the Social Security payroll tax from 6.2% to 4.2% for 2011. 

Can I Buy More Than One Property in My 1031 Exchange?

There is a common misconception that taxpayers who are completing a 1031 exchange can only sell one relinquished property and buy one replacement property, and nothing could be further from the truth. One of the benefits of the 1031 exchange is the ability to use the 1031 exchange strategy to diversify or consolidate your investment portfolio.

Diversification Strategy
Generally, younger investors are trying to trade up in value by selling one relinquished property and buy two or more replacement properties. This will usually provide them with more units, more cash flow and better diversification (risk management).

Consolidation Strategy
The opposite of the diversification strategy is the consolidation strategy. This is often implemented by taxpayers that are apporaching retirement or are in retirement and are tired of the property management headaches involved with owning investment property. It is a very effective life simplification strategy by selling more than one relinquished property and buying fewer replacement properties or properties that are easy to maintain and manage.

Tax Deferred Solution
1031 exchanges allow taxpayers to reposition or rebalance their investment portfolios by selling and buying one or more properties without having to pay depreciation recapture taxes and capital gain taxes. The only downside is that it does require that you buy replacement property in order to defer the payment of your income taxes.

Taxpayers that are not interested in buying more investment properties will need to look for other tax deferral solutions. They might want to consider the Deferred Sales Trust.