Is a Tax Deferred Exchange the Right Choice for You?

One frequently overlooked option when selling investment property is simply selling and paying taxes instead of engaging in a tax deferred exchange pursuant to IRC §1031. The commercial real estate market is white hot. Owners who saw their equity shrink or disappear a few years ago are receiving unsolicited offers that result in substantial profits.

There is the urge to sell and quickly exchange into a “better” property while the getting is good. The obvious choice would seem to favor using an IRC §1031 exchange to defer taxes, thus increasing the leverage into a new property. However, take a moment to consider the possibility that paying taxes now may be the best approach.

Tax Deferred Exchange = Inflexibility

An exchange, while deferring taxes, creates an inflexible timeline. You must identify replacement property (usually up to 3) within 45 days of closing the sale of your relinquished property. You must then purchase one or more of the identified properties within 180 days of the closing.

The white hot market that creates all the demand for your property also means that prices are high and choices limited for replacement properties. With only 45 days to act, it is difficult to review available properties and identify those which make economic sense.

Often there are multiple offers on the same properties, leaving no guaranty you will even have the opportunity to close. Once the 45 day identification period expires, no other properties may be added. With only 135 more days to close, you may be stuck with closing on a poor third choice.

Lender delays, unexpected physical or economic problems, and unscrupulous sellers increasing the price or forcing concessions are all very real possibilities. The pressures of the time deadlines make rational decision making difficult.

Tax Burden Not as Bad

Selling your property and paying taxes may not cost as much as you may think. Even under IRC §1031 tax deferred exchange, you may have to pay some taxes. Ending up with cash or exchanging depreciated property can have tax consequences.

Long term capital gains rates have fallen over the years, making the tax bite smaller. Also, paying taxes now may increase the depreciable basis in a new property, giving you tax advantages in the future. Only by consulting with a qualified tax accountant can the true costs of a sale versus an exchange be calculated.

The biggest advantage to not engaging in an IRC §1031 exchange is the freedom to make choices on how to use your funds based on your individual needs, not on an artificially imposed timeline. You can take the time to locate a good replacement property which makes economic sense. You may even decide another type of investment is a better choice.

If you are considering selling your investment property, we strongly encourage you to consult with a qualified tax advisor prior to listing the property to determine the best structure for you. We work with many qualified CPA’s who can calculate your tax exposure. The earlier in the process this occurs, the more likely you will have a successful long term result from your transaction.