Tax Strategy: Defer Capital Gains Tax with 1031 Exchange

Challenge

Fischer Cunnane’s client, a partnership entity, purchased a significant data center, then later sold it, netting a $100M gain. While the gain was exceptional, the tax burden loomed large.

Innovative Approach

Fischer Cunnane recommended incorporating a 1031 Exchange, which allows for deferment of taxes. This can be beneficial when an individual or partnership owns property that a third party wishes to purchase, which will result in a significant gain.

To execute the 1031 Exchange, the purchase of a U.S. property(s) of equal or greater value must be identified within 45 days from the date of sale of the relinquished investment property, with the caveat that the replacement property(s) may not be used for personal use.

Our client identified rental properties that met the qualification. The properties must be described in writing in a document signed by the purchaser and delivered to a person involved in the exchange (such as the seller). The exchange must be set up before closing and completed within 180 days of the sale. The exchange is reported to the IRS with the tax return for the year in which the exchange occurred.

In addition, our client wished to finance the purchase of the new rental properties. Under the rules of a 1031 Exchange, financing may only happen after the sale of the original property.

Outcome

Use of the 1031 Exchange plan allowed profits from the sale of the investment property to roll over to the next investment, thus deferring capital gains taxes until the replacement properties are eventually sold. Proceeds from refinancing were then distributed to the partners of the partnership tax free.

In addition, “profits interest,” also known as “carry interest” in a partnership enables the manager of the entity to write within the partner agreement that he or she may be awarded a profits interest once the partnership achieves “x” amount of return on investment. This enables the manager of the partnership to receive additional allocation of profits.

Note: While Like-Kind exchanges can be quite beneficial, they can also be complicated. Consult a tax professional and/or refer to IRS publications for assistance.