For purposes of complex estate planning and wealth preservation, a 1031 tax-deferred exchange can provide an effective means of deferring the recognition of — and, hence, the tax liability for — capital gains on the sale of property held for income or investment.
The structure of a tax-deferred exchange makes it uniquely useful in estate planning, particularly in light of the increased estate tax exemption created by the Tax Cuts and Jobs Act of 2017.
When a tax-deferred exchange is structured correctly, you may be able to successfully defer capital gains tax liability indefinitely and potentially eliminate it.
How Do 1031 Tax-Deferred Exchanges Work?
Section 1031 establishes the basis for a tax-deferred property exchange. Upon the sale of real property held for income or investment, you must immediately reinvest your gains into another property of like kind, which must be of equal or greater value than that of the relinquished property.
The parameters of this program require that you never take possession of the gains — otherwise you become liable for taxes. To facilitate this aspect of the transaction, you must have the sale proceeds deposited directly into an IRS-approved safe harbor. This can be a qualified intermediary (QI), a qualified escrow account or some types of trusts.
How 1031 Exchanges Can Benefit Estate Planning
You can legally continue to defer the recognition of capital gains indefinitely this way, either by holding the exchanged property or making subsequent exchange transactions.
Should you elect to pass a 1031 exchange property to an heir or designee upon your death, they receive the property at stepped-up basis value with no recognition of appreciation. In other words, they will not be subject to capital gains tax upon the sale of said property.
Your tax attorney can advise you as to how any tax liability may affect your heirs, but with the increased estate tax exemption included in the Tax Cuts and Jobs Act, the exemption for a single person is $11 million, and for a married couple, $22 million.
When Should You Consider a 1031 Exchange?
If you have unused capital in an income or investment property, consult your tax attorney or investment advisor about the potential benefits of a selling the property in a 1031 exchange transaction. Although this strategy is not appropriate for everyone, your estate planning lawyer can help you explore the potential of how an exchange could benefit you.
It is important to note that the 2017 Tax Cuts and Jobs Act made several significant changes to Section 1031. Most notably, personal property is no longer eligible for deferral. In addition, licenses, franchise agreements, distribution rights, antiques, artwork and collectible items are now exempt also.
However, the Act did implement a new, short-term deferred exchange program known as Qualified Opportunity Fund (QOF) investing. QOF funds offer several substantial benefits in terms of reducing and potentially eliminating capital gains tax liability on certain types of investments. The program ends soon, so it may be worth having a conversation with a tax attorney ASAP.
To determine whether a 1031 or another type of tax-deferred property exchange might be appropriate in the context of your estate plan, contact one of the tax attorneys of Cantley Dietrich today.