When your tax deferred investments reach the point where there is a need to sell them, you may be able to defer taxes even longer with a tax deferred exchange.  This tax benefit does not apply to all types of investments, but it's worth considering if you own real estate, life insurance contracts or some types of hard assets.  There are basically two types of tax deferred exchanges.

Tax deferred exchanges permit taxpayers to defer the recognition of income and the payment of tax on the disposition of certain kinds of property when it is exchanged for like-kind property of equal value. The adjusted tax cost (basis) of the property given is transferred to the property acquired. If the value of the property given is more than the value of the property acquired, then the seller generally receives cash or promissory notes for the difference and a portion of the gain is recognized and subject to tax. When the value of the property given is less than the value of the property received, the seller generally pays cash or gives a promissory note to the buyer and that amount increases the tax basis of the property acquired.

Types of tax deferred exchanges

     A.   Section 1031 exchanges of like kind property held for business or investment purposes, and

     B.   Section 1035 exchanges of certain types of life insurance and annuity contracts.

Examples of Like Kind Exchanges

• investment or business real estate for other investment or business real estate
• coins and collectibles that are substantially identical
• insurance for annuity contracts or an annuity for another annuity

Benefits of tax deferred exchanges

• defers the capital gains tax and permits continued investment of tax dollars
• provides an opportunity for diversification of a large investment into smaller units
• permits a substantial change in the nature of real property owned
• avoids depreciation recapture as with an installment sale
• insurance policies can be converted into life income annuities
• a fixed return annuity can be converted into a variable annuity or vice-versa

Some of the pitfalls of tax deferred exchanges

• you can't make a tax deferred swap of stocks or bonds
• you can't exchange personal use property for investment/business property
• most real estate exchanges will require the help of a specialist broker
• you can't exchange U.S. property for foreign property or contracts
• any cash or property (boot) received may be taxable
• any net debt forgiveness or reduction by assumption will be taxable
• exchanges with a related person who sells the property in two years may trigger gain

IRC 1031 Tax Deferred Exchange

When your appreciated real estate reaches the point where there is a need to sell, you may be able to defer taxes even longer with a tax deferred exchange. 

For example, raw land that has increased greatly in value might be exchanged for an apartment building or office building that is fully developed and generating cash flow.  A factory building might be exchanged for raw land or for a shopping center.  

The tax deferred exchange is usually better than selling the property, paying the tax and then reinvesting in a different kind of real estate.  But it won't help to avoid taxes on appreciated assets that are being sold and reinvested in different types of investments or not being reinvested at all. 

The alternative to a tax deferred exchange is to sell the property, pay the capital gains tax and then reinvest the after tax proceeds in some other investment. If the money were reinvested in other depreciable real estate, the new real estate can be depreciated, thereby reducing your current income taxes. The problem with this concept is that the loss of asset value and earning power is greater than the tax savings, unless the old property was not earning any income or not growing in value. 

Some capital gains taxes may be due on a tax deferred exchange to the extent of any "boot" received in the exchange. That includes the assumption of a mortgage by the other party to the exchange or a payment of cash (or other property) to equalize the values of the exchanged properties. 

The basis of the property received is equal to the basis of the property given, adjusted for the effect of any "boot" received or paid. 

If you enter into a tax free exchange with a related person and if that person disposes of the property within two years after the exchange, you may be subject to taxes on the deferred gain. For this purpose, a "related person" includes parents, children, siblings, a spouse and entities controlled by the taxpayer - including partnerships in which the taxpayer has a 50% interest. 

A tax deferred exchange of real estate usually requires the help of a real estate broker who is a specialist in such exchanges. The property you exchange must be held for "productive use in a trade or business or for investment".  It must be exchanged for property that is of a "like kind". 

The 1997 tax law includes a provision [Act Section 1052(a)] that treats foreign replacement property as not being of a "like kind" with respect to U.S. property. This rule used to apply to real estate, but it now applies to other forms of property in connection with like kind exchanges of property held for business or investment or insurance and annuity contracts. For U.S. expatriates, the new law tightens the rules to prohibit the use of tax free exchanges for five years before and ten years after giving up citizenship in order to avoid U.S. taxes.

With respect to annuities and insurance contracts, section 1035 permits owners of most types of life insurance, endowment or annuity contracts to exchange policies tax free - but the rules are restrictive.   Generally, a life insurance contract can be swapped for another life insurance contract, an endowment contract or an annuity contract.  Endowment contracts can be swapped for other endowment contracts or for an annuity contract but not for a life insurance policy.  And ... annuity contracts can only be swapped for other annuity contracts.  A fixed contract can be exchanged for a variable contract and the exchange can be between different issuers.  However, it's no longer possible to have a tax free exchange of insurance, endowment or annuity contracts between a U.S. insurance company and a foreign insurance company. 

In the case of depreciable real estate or other depreciable property, there is no depreciation recapture in a tax deferred exchange. Some commentators have suggested that it might be desirable with depreciable real estate to sell the property, pay the capital gains taxes and then buy replacement property that can be depreciated in terms of the new and higher value. However, I've found that this is seldom worthwhile if you run the numbers with both alternatives and compare the two choices on an after tax basis.

The tax deferred exchange does not directly reduce your taxable investment income - only your capital gains. 

The alternative to a tax deferred exchange is to sell the property, pay the capital gains tax and then reinvest the after tax proceeds in some other investment. If the money were reinvested in other depreciable real estate, the new real estate can be depreciated, thereby reducing your current income taxes. The problem with this concept is that the loss of asset value and earning power is greater than the tax savings, unless the old property was not earning any income or not growing in value. A number of years ago, a real estate investor hired me to develop a computer analysis to compare a tax deferred exchange to selling the property and reinvesting the proceeds. The tax deferred exchange was the best choice. And ... that was when there was a 60% tax deduction for long term capital gains. Today, the tax deferred exchange would be an even better choice. 

If you enter into a tax free exchange with a related person and if that person disposes of the property within two years after the exchange, you may be subject to taxes on the deferred gain. For this purpose, a "related person" includes parents, children, siblings, a spouse and entities controlled by the taxpayer - including partnerships in which the taxpayer has a 50% interest. 

A tax deferred exchange will result in more money to your heirs after taxes, even though it will also generate more estate taxes. For example, if you owned property worth $1 million that had a zero cost (after depreciation), the capital gains tax if you sold it would be about $250,000 if all of the depreciation were subject to recapture. If you then died, your estate would have $750,000 worth of property. If you would be in the 45% estate tax bracket, a sale of the property would result in $337,500 of estate taxes and your heirs would get $412,500. 

If you exchanged the property for other like kind property, the full $1 million would be included in your estate. Your estate would have to pay $450,000 in estate taxes and your heirs would get the other $550,000 - assuming the property was sold for that much by the estate. 

The full face amount of insurance, endowment or annuity policies owned by the insured are included in the estate of the insured and are subject to estate taxes - even though the policy proceeds are payable to a named beneficiary rather than to the estate. An annuity contract that provides for continuing payments after your death will generate taxable income for the person who is named as a successor beneficiary. (You are the primary beneficiary.) The untaxed value of the annuity contract will be treated as an asset of the estate and that money will be subject to income tax when it's paid to your heirs. However, they will be able to take an income tax deduction for any estate taxes attributable to the inclusion of the contract in your estate. 

Tax free exchanges are appropriate for most kinds of real estate and for exchanges of one kind of insurance or annuity contract for another. They can be used to convert property that produces very little income into a property that has a higher income, or vice versa.

Exchanges of insurance and annuity contracts are very useful when you want to convert from a fixed return product to a variable return product or vice versa. You can also use this tax deferred exchange rule to move an insurance or annuity product from one company to another if you have reason to be concerned about the solvency of a company that has issued a life or annuity contract for you. Sometimes, you might want to use exchanges to break a contract into separate parts (particularly annuity contracts) so that different heirs can be named as successor beneficiaries to the different policies or contracts.

A tax deferred exchange of real estate usually requires the help of a real estate broker who is a specialist in such exchanges. A tax deferred exchange of an insurance or annuity contract for another contract will require the help of an insurance agent. Tax deferred exchanges of other types of property that meet the "like kind" rules are usually accomplished on an informal basis between parties who are both familiar with the type of property being exchanged. 

The property you exchange must be held for "productive use in a trade or business or for investment".  It must be exchanged for property that is of a "like kind". 

Generally, if you exchange property subject to a mortgage, the assumption of the mortgage by the buyer/exchanger is the same as receiving cash from the buyer. Thus, the tax deferral really applies only to the equity in the property you are exchanging.

Exchanges of real estate can seldom be executed on a simultaneous property for property basis. The broker will usually attempt to find a buyer for your property. Then he will try to find someone who is willing to sell the kind of property you want to acquire. It's rare when the seller of the type of property that want to acquire is interested in owning the type of property you want to sell.  Then the broker may involve a third property in order to facilitate an exchange. In some cases, there is a delay in selling one property and acquiring another. 

For many years, the IRS denied tax free exchange treatment for exchanges that were not simultaneous, but they capitulated after losing as case called "The Starker Case". Such delayed exchanges are now permitted so long as the replacement property is identified within 45 days and the exchange is completed within 180 days.  

Source: By Vernon Jacobs - The Offshore Press, www.offshorepress.com

Vernon K. Jacobs is a CPA, a Chartered Life Underwriter and a Fellow of the Life Management Institute. He is an international tax practitioner and tax author with a focus on international investing and insurance. He has been a college instructor in accounting, personal finance and corporate taxation, and has been a speaker at dozens of professional conferences and seminars. www.vernonjacobs.com

Maxim Global Wealth Advisors is a premier wealth advisor for both American expatriates and foreign nationals with a connection to the US.  Maxim specializes in comprehensive wealth strategies including investment management, tax strategies, and retirement planning.  We created our Knowledge Library in order to help expats and multi-nationals increase their financial intelligence and to enable well-informed decisions. We hope you find this information useful and we invite you to contact us for more information on our wealth management services.

Maxim Global Wealth Advisors      -      www.maximadvisors.com