Taxes on capital gains are about to increase substantially effective January 1, 2011. The tax cuts established during the first few years of the Bush Administration will, or are at least slated to, automatically sunset as of January 1, 2011. Not only will capital gains taxes increase, but an additional tax of 3.8% will also be incurred by high income earners making over $200,000 (single taxpayer) and $250,000 (married) shortly thereafter. These two changes will increase the top capital gains rate from 15% to 23.8% in only a few years time. For business owners looking to sell or exit, not everyone will be able to exit their businesses before these new rates come about. It is with this in mind, that the like-kind exchange or Internal Revenue Code Section “1031 Exchange” will become critically important once again.
The Internal Revenue Code states that no gain or loss is recognized on the exchange of property held for productive use in a trade or business or for investment if the property received in exchange is of like-kind and is held for productive use in a business or for investment. Non-recognition does not apply to stocks, bonds and notes, certificates of trust, beneficial interests, partnership interests, or securities. Like-kind exchanges also do not apply to exchanges of property the taxpayer uses for personal purposes. Personal use property includes personal residences and personal automobiles among other property. With that said, it is important to understand why the law is in existence and what it means. Congress is always interested in promoting investments in the economy. Taxes typically stifle investment value. In an attempt to limit the amount of taxes that are charged in investment transactions, Congress, long ago, created a section of the code that eliminates taxes due on appreciated property in specific transactions, known as Section 1031 transactions.
Exchanges of Non-Real Property
Property eligible for exchange treatment is best classified into two categories for simplicity. The two categories are non-real and real property. The first category, non-real property or personal use property is the more difficult of the two categories to handle. Non-real property is divided into different classes of goods which are simply too many to list here.
However, some of the easier transactions in the non-real property categories include the following: light trucks must be exchanged for light trucks, animals must be exchanged for essentially the same animal, and similar equipment must be exchanged for other similar equipment.
Exchanges of Real Property
This has been said to be exchanging “dirt-for-dirt”. The requirements for exchanging real property are not nearly as stringent as for non-real property. As a matter of public tax policy, this is probably because real property typically appreciates in value and non-real or personal property will tend to depreciate with business use.
Tax Savings Effect
When exchanging like-kind property for like-kind property, no gain or loss is recognized. The basis or amount on the books for the property remains the same. Therefore, when the property is exchanged the result is that no tax is due or payable on the transaction.
For those looking to exit a business, consider exchanging your building for a productive property in the country, of which you could possibly make partial personal use of in the future. The person desiring your business in this instance, if he/she doesn’t already own productive land that you want, can purchase land and exchange it with you for your building. There are all kinds of ways one can structure a like-kind exchange. Simply stated, you are not limited to doing a simple swap.
Because capital gains taxes will increase in the near future, efficient tax planning has become absolutely critical to retirement planning. Facing a business sale of a multi-million dollar operation once the tax rates go up, may mean paying hundreds of thousands of dollars more in taxes if the proper tax planning is not taken into account. Using like-kind exchanges is one approach that a succession specialist can use to reduce tax liabilities when the time comes for an owner to exit a business.
Like-kind exchanges were enacted to encourage efficient use and exchange of assets. Structuring transactions to use this code section will defer tax expense until a later fiscal year in most cases. The tax savings can be substantial, and the time and cash value of the deferral, especially on an exchange of real property, can be enormous. Contact the professionals at The Center for further advice on this tax strategy.
By: Dr. Bart Basi at the Center for Financial, Legal and Tax Planning for Transworld M&A Advisors