Perfect 1031 Swap
There is an untold secret for those own real estate investments. They can save tax big time!
Excuse me. Let me take it back because it sounds too much like a selling tactic for a get-rich-quick book. I am talking about 1031 like-kind exchange, and this is not a super secrecy either.
How does it work
This is one of those tax saving strategies dubbed by the name of the tax code. Basically, you pay zero tax on capital gains when you exchange your property for a similar property of equal or higher value. You can keep doing the exchange as you are building up the value of your investment. You will eventually pay the tax if you decide to cash out and exit the exchange loops. However, combined with other strategies, such as using living trust, you can pass the property to your children without any capital gains tax permanently.
This is one of those nice things rarely happen in the tax world. Yes, it does sound too good to be true, but it is not impossible. Thanks to the powerful real estate industry and its lobbyists. Technically, you need to do it right of course and it requires good planning. There are companies out there to help you to achieve this. They are usually the specialized title companies or other Qualified Intermediary companies.
A perfect example, but…
There is one more story to tell. A real estate company got offers to buy two of its nice properties. They decided to do 1031 swaps in order to save tax. Therefore, these two properties were transferred to an independent intermediary company, which in turn sold the properties to the interested buyers, and brought replacement land from another company. So far so good. This is a perfect 1031 exchange pattern!
This is a real court case, and the court ruled that this exchange did not qualify. The problem is that the seller of the land is a subsidiary of the real estate company. Also, this subsidiary didn’t pay any tax on the sale of the land because it had other losses to offset the gains. This court thinks this is a perfect setup to save tax among related parties.
The lesson of the story? When you find perfect arrangement to save tax and win-win for everyone while leaving IRS the only loser, most likely you won’t be the last one laughing.
![Recommend [mattcpa]](http://s3.amazonaws.com/arkayne-media/img/logo-recommend-me.png){kind=logo}
So his taxes will be deferred to some date in future. Commercial Property
Absolutely, 1031 exchange allows you to pay no capital gains tax until later date when you sell your investment. For example, if you have Property A with cost basis of $30K and market value of $50K. If you sell it, you need to pay tax on the $20 capital gain. If you exchange it with Property B with value of $80K, you pay no tax, until you sell Property B. Of course, you can exchange for Property C and so on. As usual, there are many specific logistic requirements to do this. Thanks for the comment.
Matt, I have an insurance agency that I am considering selling in 2010 that
appears to have NO basis.
In 2000, the company I worked for as an employee for almost 20 years
“fired” all of their employee agents and allowed them to become
independent contractors, thus I dont know where I could start looking
for any basis. Prior to 2000, I used Form 2106 Employeed Business Expenses to declare business expense and Schedule C from 2000 to date.
My question is this…if I receive a lump sum of about 25% of the sale
price and structure a secured settlement with the buyer for, say 7
years, I want to find the most legitimate ways to minimize or avoid,
if legally doing so, any capital gains.
Also, I read that NYS taxes capital gains the same as ordinary income, wow,
I will get killed since I can’t establish any basis and I need cash to pay off outstanding debt and some back taxes.
Are there specific clauses, stipulations that must be in the sales
contract (non-compete, good will, etc) that would help me decrease any
CG taxes or, for that matter, if I omit certain clauses, would I be
liable for more capital gains?
Where the IRS imposes a 15% capital gains tax, what about NY State and
NY city?…I am a sole proprietor and age 62 and I am in about a 28%
tax bracket. From what I understand, I will pay regular taxes on any
income I earn for the year of sale but only pay the CG taxes on the
sales proceeds.
Of course I have intentions of seeing a tax professional but I need to
get some idea what I’m looking at before I even meet with prospective
buyers. Any advice or avenue of directions is greatly needed and appreciated.
Steve – Very interesting scenario. You’ve got me thinking. Sec 1031 exchange is mostly for “like-kind” business properties, such as real estate investment, so exchange of business interest is not qualified.
As sole proprietorship, your basis should be whatever you invested in your assets, such as office furniture, computers or anything you used in the trade. The only valuable thing for a potential buyer should be your customer list or the reputation of your personal service. I agree that it is easier to assign a selling price than a costs to those items.
You are very likely to pay regular tax on the gain on the equipments and etc, but capital gain tax on the customer list and goodwill. For 2010, long term capital gain rate is still 15%, expecting a change to 20% in 2011. You are right that New York, just like many other states, does not provide favorable rate for capital gain. New York rate is 6.85% while our rate here in California is 9.3%, considering yourself lucky still
Well, I take it back, you are subject to New York City tax as well (another 2 or 3%), so probably we even then.
I know you are probably seeking an exit strategy for retirement. It is very hard to sell a business in the form of sole proprietorship because all assets and debts are tied to you personally. Even the value of goodwill is hinged on your personal service. Without you, the goodwill vanish quickly, and customer may be leaving as well.
To solve both problems, have you thought about converting your business into a LLC? Then you can take in new partner(s) who are interested in taking over the business. The incentive is that your presence will help maintain the critical on-going relationship with the customers until certain expected date. Within the LLC, you can gradually give up ownership percentage, and you can structure the payments to you in any form or time. In other words, you can control your payment flow suitable to your tax circumstances.
This is similar to installment sale. One drawback for installment sale is that seller has to rely on the capability of the successor, but this idea is different, when the partners (buyers) come on board early (before your full retirement), you are pretty much still involved. You can cash out gradually when you are still in control. If they bring in investment to the LLC, that will strengthen the business value and the health cash flow too. As far as the form of payment, you have many options, salary, right out distribution, payment to life insurance, contribution to retirement plants, etc.
Anyway, just consider this my wild brainstorming effort for you, you may work this out with your advisors of course.