Case Studies In The 1031 Tax-Free Exchanges

Jane considers selling her property and will net 2.6 million dollars after selling expenses. Her tax liability on the gain of $2,320,000 ($2,600,000 - 280,000) would be $650,000. Jane would then have $1,950,000 left to invest. After checking with her banker, she decides that with a five year "Super Zip" C.D., she will earn 2.96% for an annual income of $57,720.

After checking with her REALTOR, Jane decides that with a tax-free exchange, she can find net leased warehouses (tenant pays the expenses) for 10% annual cash return. The warehouse are each leased to different parties, and her annual income is $260,000 with less exposure to inflation. Jane chooses the exchange. As an additional benefit, Jane also has an annual depreciation deduction of $6,410 (carryover building basis of $250,000 divided by 39 years).

After some discussion, the partners decide to liquidate and ask you how to reduce the tax consequences. The apartment is now worth $5.8 million and have an adjusted basis of 1 million dollars. The total gain on the sale will be 4.8 million or 1.2 million for each partner.

Solution 1. They sell the apartments and each partner pays $336,000 ($1.2 million x 28%) in taxes.

Solution 2. The partners convert their partnership interest to a tenancy-in-common. After a year, each former partner exchanges his interest for other business or investment real estate.

After recently moving to Midland, Jan decides that it would be more convenient to have rental property closer to her new home. Jan decides to have a delayed exchange after finding a buyer for her California house and replace it with three rent houses in Midland. Since her California house sold for $140,000, her tax saving amounts to $35,840 which is 28% of ($140,000 - 12,000)

Generally whenever someone sells or trades any type of property, a gain or loss for tax purposes results. The gain or loss is the difference between the amount realized (cash or value of property received) and the adjusted basis (cost of the property given up minus any depreciation or depletion).

In the early years after the passage of the income tax in 1913, there were many discussions concerning the timing or "recognition" of income for tax purposes. If a farmer trades one horse for another horse, then should he be required to put it on his tax return? What if the farmer trades a horse for a tractor? After much debate in 1921, Congress in it's infinite wisdom decided that an exchange of like kind property should not be an occasion to pay tax. For tax purposes, the "basis" of the old property is merely transferred to the new property.

Over the years, the rules for a tax-free exchange have slowly evolved, but two primary concerns have prevailed: 1) What form of transaction qualifies for tax free treatment and 2) What is like- kind property? In the early days an exchange was merely a trade between two parties. Currently the two party transaction probably only makes up less than 1% of all tax-free exchanges. The most flexible and popular exchange involves a trade with an accommodator or intermediary for the purpose of selling property to one person and acquiring replacement property from yet another at a later date. Sometimes the transaction is simple and at others quite complex depending on the goals and present circumstances of the parties involved. The form of the transaction and it's documentation is critical and determines if it is taxable or not. Since tax law can be quite complex, this is not a transaction to be designed and documented at home on the kitchen table or by the inexperienced as a self-help activity. A tax practitioner with oil and gas experience can usually provide good guidance in the transaction.

The definition of what is "like-kind" property is generally easier when dealing with real estate. Real estate is usually land and anything permanently attached to the land. With perhaps one exception any form of real estate is considered like-kind to any other form of real estate. In other words, you can exchange a working or royalty interest for another working or royalty interest or even a ranch, hotel or office building. A production payment is considered to be real estate under Texas law but is treated as a form of indebtedness for tax purposes and consequently may not be considered like-kind. An exchange of a working interest while retaining a royalty interest or surface rights is usually treated as a lease rather than a disposition and will not qualify for a tax-free exchange. If a production payment were retained, the transaction would probably qualify for tax-free treatment. Equipment, furniture, and other personal property can only be exchanged tax-free for very similar types of equipment or furniture. Most exchanges of working interests involve some degree of both equipment (usually 5-10%) and real estate. For example, if you sold in a tax-free exchange a mineral interest for say $900,000 and related equipment for $100,000 in order to be tax-free you would need to receive a mineral interest with a value of $900,000 or greater and well equipment with a value of $100,000 or more. Also to be tax-free in this example, you must not receive any thing that is not like-kind property such as cash, notes of indebtedness, net relief of indebtedness or say as an airplane.

We are frequently asked if the exchange is tax-free or merely tax-deferred. The result can be either. If the replacement property is later sold outright then the benefit is just deferral. If the replacement property is either held until death or exchanged until death the deferred tax evaporates with the step up in basis and the previous exchange the effectively is tax-free. It has also been observed, that if someone manages to defer taxes for a relatively long period, say 15 years, the transaction is effectively tax-free, because of the relatively low present value of the dollar paid sixteen years hence.