Like Kind Exchanges

If you have been paying attention to the new tax laws you are probably aware of the 3.8% Medicare surtax that was included by Congress as a means of raising additional tax dollars. Essentially, this tax is imposed upon singles with modified adjusted gross income of over $200,000 and married couples with over $250,000 (talk about a marriage penalty – same-sex couples thinking they will get a break by filing married instead of single need to be aware of this sort of trap in the tax law). This surtax is levied against so-called “investment income” defined as interest, dividends, capital gains, annuities, royalties and passive rental income. Most of these types of income are pretty well set and there is little you can do to protect yourself from the effects. However, if the sale of an asset will result in capital gain, you have a couple of options that could save you the 3.8% surtax.

One of them is an installment sale. Here you calculate the percentage of the sale which is the result of gain. If you own a piece of property that you sell for $500,000 and your undepreciated basis is $200,000, your gain is $300,000 or 60%. If you claim the entire gain in the year of sale the surtax will take a big bite. If, however, you do an installment sale (where you accept payments over a period of years) your capital gain will only be 60% of whatever you collect in principle for that year. Without question this approach can save appreciable tax dollars. However, if the capital gains tax rate should increase in the future, the increase will be applied to any remaining principle collected; this COULD be a major drawback.

The other method is the like-kind exchange (IRS Code Sec 1031). This method has been around for a long time and can be very useful in minimizing taxes in certain situations. What happens in the like-kind exchange is that the owner of property A finds someone who would like to acquire property A. This other party owns property B and offers to trade B for A. We most often think in terms of real estate traded for other real estate. In reality, any type of business (or investment) property could be subject to a like kind exchange. It is not uncommon for a business operator to trade in the business vehicle for a newer model, for example. The result is a like-kind exchange.

So how does it work? Let’s take the example of a farmer who has owned 160 acres of land for many years and has a basis (usually acquisition cost) of $200 per acre. This means the total basis is $32,000. In my home state of Iowa, a good acre of farm land sells for as much as $11,000 and up. That means today our 160 acres could sell for $1,760,000 yielding a capital gain of $1,728,000. The Medicare surtax of 3.8% would increase the tax bite by well over $65,000, on top of whatever the capital gains rate happens to be (probably 20% by next year). Now let’s say that the farmer (who is ready to retire and loves to fish) finds someone with a great little resort on a lake in Florida for sale for about the same price. Both properties are businesses and both of them are real estate so they would qualify for like-kind exchange treatment. In this ultra-simplistic example, the farmer makes the trade and now owns the resort. His basis in the resort is only $32,000 (the same as the basis of the farm land he gave up). The really good news is that neither party in this transaction would have ANY tax consequences as a result of the exchange.

As with any tax-saving strategy, there are other considerations. Let’s say that the farmer gets $100,000 to “boot”, meaning the farm was worth $100,000 more on the market than was the resort. This “boot” of $100,000 is taxable income to the farmer. If on the other hand the farmer has to give up $100,000 in “boot”, the basis of the resort will be increased by the “boot”.

There are professionals who specialize in helping arrange like-kind exchanges. It would be serendipity of the highest order for our farmer to locate the resort owner without this kind of assistance. However, the professional acts as a broker in putting together two parties each with a property desired by the other. Your Sec 1031 exchange professional will be able to guide you through the maze of other rules (such as related taxpayers, transfer of liabilities, time limits, etc.) so that the transaction will stand up to IRS scrutiny.

As we go forward into the time when the new tax laws take effect, tax planning becomes even more crucial that it has been in the past. Broaden your horizons and think outside the box. My best advice to my clients is this: if you are considering a significant financial transaction please give me a call first so that I can apprise you of any tax problems that might be created by the transaction. Your personal tax advisor should be happy to examine these situations with you. If you need help beyond that, feel free to contact me a

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