WHY DO TAXPAYERS EXCHANGE
Clearly, the overriding reason is the ability to defer payment of capital gain taxes, including the recapture of depreciation. With depreciation recapture at 25% (or more, depending upon the type of depreciation taken and the period over which that depreciation was taken) and federal capital gain tax at a minimum of 15%, plus state capital gain taxes (depending upon the state, of course), taxes can easily account for 30% or more of the gain recognized. But deferring taxes isn't why taxpayers exchange. Taxpayers have a primary reason for moving their invested dollars from one investment to another. Tax deferral is simply a desired accompaniment to the main reason a taxpayer sells investment property that enables the taxpayer to deploy more money into the new investment. Why do investors sell and where can an exchange help? Here are some of those situations:
- Consolidation. Example - taxpayer owns several properties, perhaps in different states, and wishes to consolidate his holdings into one property.
- Diversification. Example - taxpayer owns one large property and wishes to diversify her holdings over a wider group of properties.
- Relocation. Example - taxpayer has moved to new location and wishes to move his investment to the same location.
- Reduction of management headaches. Example - taxpayer has owned high-maintenance property and wishes to reduce management responsibilities by exchanging into triple-net leased property.
- Solution to partnership problems. With proper advance planning, property owned by a partnership can be sold and the partners can go their own ways, some choosing to exchange and others cashing out.
- Increase cash flow. Example - taxpayer owns raw land that produces little or no income and wishes to exchange into income-producing property.
- Estate planning reasons. Example - taxpayer owns one property but has three heirs who do not agree on how to dispose of the property after the death of the taxpayer. Taxpayer can exchange out of one property into three similar properties and each heir can decide how to handle his or her own property.
- Re-leveraging of equity. As each year of ownership passes, one's equity in a property typically increases. Generally, the return on equity that the property produces decreases annually. Exchanging allows a taxpayer to re-leverage her equity.
- The increase of equity by buying at a discount. If you believe, as the old real estate adage goes, "You make your money when you buy," should you not buy more often? A rhetorical question, to be sure, but if you are able to buy at a discount, tax-deferred exchanges can create wealth more quickly than any other technique.
- Debt issues. Example - taxpayer owns a fleet of vehicles for his business. His old practice was to sell 25% of them each year and replace them with new vehicles. By taking the maximum deductions, his accountant advised him that he came out ahead by borrowing the money to purchase the new vehicles. In today's world, where borrowing is more difficult, the savvy business owner recognizes that by structuring this transaction within a 1031 exchange, he can reduce or eliminate his need to borrow money and likely end up ahead in both cash flow and tax benefits.