A tax-deferred exchange permits investors to defer tax on capital gains
indefinitely. To some extent, the benefit of tax-deferral depends on tax rates that
apply in the future when there is a taxable disposition of the investment
property. Obviously, if tax rates increase significantly, one might benefit from
paying taxes today at lower rates.
The federal tax rate on long-term capital gains for most taxpayers is currently
fifteen percent (15%). If Congress fails to extend that rate, then the tax rate on
long-term capital gains will increase to twenty percent (20%) in 2013. In
addition, the national health care reform legislation that became law in March,
2010, imposes a new 3.8% tax on certain investment income beginning in 2013.
Thus, for some higher income taxpayers, the effective rate on long-term capital
gains will increase to 23.8% (not including State taxes). Given the inability of
Democrats and Republicans in Congress to agree on almost any significant
legislation in recent years, it is anybody’s guess what rates will be next year.
Accordingly, some taxpayers and their advisors have determined that they should
recognize capital gains in 2012, where possible, to lock in the current low capital
gains rate. Where tax-deferral is otherwise possible, a decision to pay tax now
constitutes a simple wager that capital gains rates will increase in the future.
One might reasonably make that bet and take the risk that Congress will extend
the current rate and eliminate the Medicare tax on gains, but is that actually
necessary? For some taxpayers, there is a better solution. What if you could sell
investment property in 2012 and, in 2013 choose whether to: (i) pay the capital
gains tax in 2013 at the 2012 rate, (ii) pay the tax in 2013 (if the favorable rate
remains in 2013), or (iii) defer the tax indefinitely with a tax-deferred exchange
under Internal Revenue Code Section 1031? For some well positioned taxpayers,
such a strategy is possible.
Section 1031 permits a taxpayer to sell appreciated property and to acquire
replacement property in a deferred exchange that extends from one tax year to
the next. A taxpayer generally has 180 days to complete the exchange. For
example, if qualifying investment property is sold in October, 2012, the taxpayer
must acquire like-kind replacement property by March of 2013. If no
replacement property is acquired by the 180th calendar day in 2013, then the
taxpayer generally recognizes some or all of the gain in 2013, when sale
proceeds are received from the qualified intermediary.
By default, the “installment sale” feature of Section 1031 effectively pushes the taxable gain
into the following tax year (in this case, 2013). This could be good or bad. If tax
rates do not increase, the incomplete 1031 exchange pushes the taxable event
forward allowing for some tax-deferral – a net benefit. If rates increase, the
higher 2013 tax may wipe out the benefit of the short tax-deferral. As it turns
out, however, the taxpayer has a choice whether to pay the tax in 2012 or 2013,
at the then applicable rates. In other words, there is no requirement that the
taxpayer pay the tax at the higher 2013 rate if rates actually do increase.
By Asset Preservation Incorporated