A 1031 Is Not the Only Path for a Property Sale

When a property owner asks his advisors what can be done about the tax on a sale, he is usually given a menu with four items on it.

Pay the tax. Exchange into like-kind property under Section 1031. Spread the payments across several years. Or hold the asset until death and let the basis adjust.

That menu is not wrong. Every item on it is legitimate, and for a great many owners one of the four is the right answer. My objection is not to the menu. My objection is that most owners are never told it is a menu at all. They are handed the exchange and told that is the option.

So let me take the exchange seriously, because it deserves that, and then say plainly what it asks of you.

What the exchange does well

Section 1031 is a green light. Congress wrote it deliberately, it has been in the code in some form for a century, and its purpose is straightforward. If you are continuing to hold investment real estate, the government is willing to let the gain ride into the replacement property rather than collecting on the turn.

For an owner who intends to stay in real estate, who has a replacement property in mind, and who is not looking for liquidity, it is an excellent provision and there is no reason to look further. I have told owners exactly that and sent them on their way.

What it asks of you

Five things, and each one has cost somebody I have worked with.

1. The clock. Forty-five days to identify the replacement property. One hundred eighty days to close. Those are calendar days and they do not care about your circumstances. I have watched owners take a property they did not want because the calendar ran out.
2. Continued ownership. You do not exit real estate. You exit this property. An owner who is seventy-eight and tired of managing buildings has not solved his actual problem.
3. Equal or greater value. To move the full gain, the replacement must match or exceed what you sold, and you must reinvest all of the proceeds. Anything you take out is boot, and boot is taxed.
4. Liquidity. Which is the same point stated from the other side. If you needed cash from this sale, the exchange is at odds with the reason you sold.
5. Basis carries forward. This is the one that gets least attention and costs the most.

Let me stay on the fifth.

The basis trap

Your basis in the replacement property is not what you paid for it. It is the basis carried over from the property you gave up, with adjustments.

That means the depreciation you have already claimed follows you. Your future depreciation deductions on a new and more valuable building are calculated on an old and much smaller number.

I worked with an owner whose property was worth $1.2 million and whose land basis had been depreciated down to a figure in the tens of thousands. He had done everything correctly. He had exchanged more than once. Each exchange was sound on its own terms. Cumulatively, he had built a position with almost no depreciation left to claim and a very large embedded gain that was going to surface eventually.

He did not know that. Nobody had drawn the line forward for him.

The concession

Everything above is a condition, not a defect. Section 1031 was never designed to solve liquidity, or exit, or diversification. It was designed to keep investment property moving without a taxable event on every turn, and it does that job well.

The failure is not in the statute. The failure is in presenting one provision as the whole of the law.

The distinction

The right question is not "should I do an exchange." The right question is "what am I actually trying to accomplish, and which provisions serve that."

An owner who wants to stay in real estate has a different answer than an owner who wants to be finished with tenants. An owner who needs cash at close has a different answer than an owner who does not. An owner with three properties has options that an owner with one does not.

Those are different problems. They should not all receive the same answer, and the reason they often do is that only one answer was ever presented.

The proof

The way to test this on your own transaction is not to argue about it. It is to run the comparison.

Put the conventional outcome in one column. Put the exchange in the second, with the clock, the reinvestment requirement, and the carried basis all shown. Put whatever else fits your facts in the remaining columns. Same format, same assumptions, side by side.

Then look at what reaches you, and at what you are obliged to do afterward, and decide.

Sometimes the exchange wins that comparison outright. When it does, I say so, and the owner proceeds with more confidence than he had before, because now he has seen the alternatives rather than assumed them away.

This information is general and is not tax, legal, or investment advice. Every situation is different. Work with your own CPA and attorney before acting on any strategy.