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Summary of Tax Deferral and Tax Exclusion Strategies

Summary of Tax Deferral and Tax Exclusion Strategies, including Sections 1031, 1033, 1034 (repealed), 721, 453 and 121 of the Internal Revenue Code

Institutions, corporations, and individuals have many tax-exclusion and tax-deferral options at their disposal, and it is vital to have a sound plan in place before proceeding in any venture involving these strategies. Following this introduction is a look at many approaches and options that can be taken into consideration before dealing with your attorneys and/or financial advisors.

Section 1035 - Exchange of Life Insurance, Endowment or Annuity Contracts

Income tax consequences can be deferred via Internal Revenue Code Section 1035, which enabled those with life insurance, annuity contracts, or policies to exchange those for other policies of a similar nature. This is known as a 1035 exchange. A Qualified Intermediary is not required in this transaction as it does not relate to real estate holdings.

Section 721 - Exchange of Property Into A Real Estate Investment Trust (REIT)

A 721 exchange (or an upREIT or 1031), which is covered by Section 721 of the Internal Revenue Code, enables you to acquire shares in a Real Estate Investment Trust (REIT) by swapping rental or investment real estate.

Normally, a 721 exchange is used hand-in-hand with acquiring new property after selling off relinquished property, as per Internal Revenue Code Section 1031. 12 to 18 months are required for the replacement property to become eligible for 1031 Exchange, as this period establishes the owner’s intent to retain the property; afterwards, as laid out in Section 721 of the Internal Revenue Code, the replacement property is contributed into a Real Estate Investment Trust. A 721 exchange does not have to take place with a 1031 Exchange; as part of a 721 exchange, the owned property can be given over right into the Real Estate Investment Trust.

This method provides more liquidity once the Real Estate Investment Trust becomes publicly traded and listed on a securities exchange when exchanging out of his or her investment real estate portfolio and into shares of a Real Estate Investment Trust. The Investor now owns securities instead of a real estate interest, therefore they have no need to use a 1031 Exchange to exchange back into real estate and defer his or her capital gain taxes.

Section 1032 - Exchange of Corporation Stock for Property

When corporate stock is received after trading for money or property, the investor shall not post any losses or gains as per Internal Revenue Code Section 1032, AKA 1032 Exchange. However, there is no need for a Qualified Intermediary when traded for real estate as this type of transaction does not apply in that case.

Section 1033 - Involuntary Conversion (Eminent Domain or Natural Disaster)

Real property can be exchanged on a tax-deferred basis for property that is similar or related to the property’s use if it is the subject of an involuntary or compulsory conversion either from condemnation via an eminent domain proceeding by local, state or Federal government as per Internal Revenue Code Section 1033. If property is destroyed by natural causes – AKA “Act of God” – an investor has two (2) calendar years to replace it, and three (3) years is the property was the subject of condemnation by eminent domain. When completing a 1033 exchange transaction a Qualified Intermediary is not needed.

Section 1031 - 1031 Exchange of Property Held for Investment

An investor may defer Federal and typically capital gain and depreciation recapture income tax liabilities as per Internal Revenue Code Section 1031 if relinquished property can be exchanged for similar property also held as rental or investment property or property used in their business. However, these exchanges are still subject to applicable taxes; replacement properties acquired can have capital gain and depreciation recapture income tax liabilities deferred into them in a 1031 Exchange. Without reducing cash position by paying capital gain or depreciation recapture taxes due to the tax deferral benefits of this procedure, an investor can dispose or convert property, providing them with the liquidity needed to increase their real estate holdings and ultimately increasing their net worth by trading up in value and improving cash flow and capital appreciation. When completing a 1031 Exchange transaction a Qualified Intermediary is needed.

Section 453 - Capital Gain Deferred with an Installment Sale Carry Back Note

When an investor carries back a promissory note or installment note on the sale of their property, Internal Revenue Code Section 453 allows them to defer their capital gain income tax liabilities. This process can be referred to as a “seller carry back note,” “installment sale treatment,” or “seller carry back financing.” An investor is able to defer the recognition of capital gain income tax liabilities until principal payments are received over the term of the promissory note if the investor sells their property and carries back a promissory note to help the buyer finance the acquisition of the property. An investor can also sell their property and receive an annuity is what is known as a “Structured Sale,” whereas capital gain on a prorata basis that is received via principal payment from the annuity is recognized. However, there is no IRS assistance available for these processes currently. Depreciation recapture cannot be deferred under an installment sale and will be recognized in the year in which the sale occurred.

Section 121 - Exclusion of Capital Gain on the Sale of Primary Residence

The tax deferral provisions contained within Internal Revenue Code Section 1034 were replaced the Taxpayer Relief Act of 1997 (taking effect as of May 7, 1997), which provides tax-free capital gain exclusion provisions pursuant to Internal Revenue Code Section 121. If the taxpayer is married and filing a joint income tax return, they may exclude up to $500,000 from their gross income in capital gains per taxpayer and up to $250,000 in capital gains if they sell real property owned and used lived in as their primary residence for at least a combined total of two (non- consecutive) years out of the last five years, although certain exceptions may apply. Taxpayers can only utilize a 121 exclusion once every two (2) years.

The Taxpayer’s capital gain tax liability in excess of the $500,000 or $250,000 limitation will be taxable, so they should be observant of accumulated capital gain in their primary residence; considerations should be given to selling their primary residence, as this would allow the Taxpayer to acquire another primary residence and preserve the tax free exclusion of the capital gain . The Taxpayer’s capital gain tax liability is in excess of the $500,000 or $250,000 limitation, legal, tax and financial planning would be required that would enable the Taxpayer to dispose of their primary residence, and diversify and allocate the capital gain tax liability, and defer all capital gain tax liability, which would allow for additional financial, tax and estate planning chances in the open market. 1031 Exchange transactions have specific rules that apply to them pursuant to Section 121 of the Internal Revenue Code.

Other Tax-Deferral and Tax Exclusion Strategies

An income tax deduction for the donation of a property or asset may be transferred into a Charitable Remainder Trust (CRT) to then be allocated to a charitable institution selected by the investor; this procedure allows them to sell a property or asset without incurring depreciation recapture or capital gain income tax liabilities. The investor can then pursue better cash flow opportunities by channeling the net sales proceeds into investments.

Disclaimer: 1031 exchange made simple does not guarantee the performance of the QI's in our referral network and we can not be held liable for any misrepresentations or mistakes in regards to a 1031 exchange by one of the QI's that we refer to you. 1031 Exchange made simple does not provide tax advice nor can we make representations regarding the tax consequences of an exchange transaction. 1031 Exchange made simple is a 1031 QI Referral Network. 1031 made simple is not responsible (in any way) for the performance, creditability, and financial condition of any QI in our network. In this new economic environment it is imperative that all potential 1031 exchange customers do their own due diligence and research on any QI that they may use, on a 1031 exchange. Please verify and check the validity of the Bonding and Insurance of your QI. It may be wise to have your 1031 exchange accounts set up as separate, individual customer accounts. Our web site is to be used as a information based web site only. All parties doing a 1031 exchange must consult their tax advisors or attorney for this information.

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